A family-owned business is often created with the goal of building a legacy and supporting future generations. However, succession planning can be a complex and sensitive undertaking. The stakes can be high, especially if real estate is part of your business’s assets. One strategy that may be used to defer capital gains taxes and align real estate holdings with long-term planning goals is the Section 1031 exchange.
Named after Section 1031 of the revenue code, this like-kind exchange allows for the deferral of capital gains taxes when one investment property is exchanged for another that meets IRS requirements. In this article, Realized 1031 shares how using 1031 exchanges for succession planning in family-owned businesses may be used as part of a broader succession planning strategy for family-owned businesses.
Refresher on 1031 Exchanges
The 1031 exchange is a tax-deferred strategy that allows investors to exchange one qualifying real estate investment for another of “like-kind” without recognizing a taxable gain at the time of the transaction. There is no official sale in this type of transaction, which means no taxable event occurs. As a result, you can defer capital gains tax payments until a triggering event occurs. This tax deferral may provide an opportunity to reposition or reallocate real estate assets without reducing equity through a taxable event.
For example, if your family business owns a commercial building acquired decades ago that has appreciated significantly, its appreciation could result in a huge capital gains liability upon sale. Using a 1031 exchange, the business may defer those taxes and reinvest the proceeds into another qualifying property—without an immediate tax obligation—potentially aligning better with the next generation’s business or investment objectives.
Benefits of 1031 Exchange Succession Planning
In the context of estate or succession planning, family business owners usually have two goals in mind.
- Minimize tax payments and preserve their wealth for their heirs.
- Simplify the handoff of complex assets like real estate.
A properly executed Section 1031 exchange can support both objectives by providing tools for deferring taxes, repositioning portfolios, and streamlining asset distribution.
Preserving Capital
One of the key advantages of a like-kind exchange is that it helps you defer capital gains taxes. Many family businesses hold highly appreciated real estate assets, which result in high tax payments upon their sale. Reinvesting these assets through a 1031 exchange enables reinvestment into other qualifying properties without immediate tax recognition, potentially preserving more capital for future planning. Plus, the family can diversify their portfolio and access new markets by exchanging new properties.
Strategic Repositioning of Assets
Succession planning helps you review whether or not your current portfolio is still able to meet your business’s operational or investment goals. While you may have preferred managing many commercial properties, maybe the next generation favors fewer high-value properties. Through a 1031 exchange, business owners can strategically transition into different property types or reduce administrative complexity—potentially making future transitions smoother for heirs.
Managing Internal Conflict Among Heirs
Real estate is traditionally a difficult asset to divide. One potential benefit of using a 1031 exchange, particularly when reinvesting into Delaware Statutory Trusts (DSTs), is that they allow you to give your heirs fractional interests instead of direct real estate ownership. Such types of assets offer more flexibility, which may reduce disputes over who gets what.
Leveraging Step-up in Basis in 1031 Exchange Estate Planning
1031 exchange properties are generally eligible for a step-up in basis after your passing. In this case, the new cost basis of the asset will be the fair market value at your death. This adjustment can reduce—or in some cases eliminate—capital gains and depreciation recapture taxes for heirs if they choose to sell shortly thereafter. While the step-up in basis offers potential tax relief, it is subject to current tax law, which may change in the future. Investors should consult with qualified estate planning and tax professionals to evaluate how this provision fits within their long-term strategy.
Considerations and Risks of Using 1031 Exchanges in Succession Planning
While 1031 exchanges can offer meaningful tax deferral and estate planning flexibility, they are not without complexity or potential downsides. Investors should be aware of the following considerations:
- Strict IRS Compliance Requirements: To qualify for tax deferral, 1031 exchanges must meet specific timing and structural rules. Missing deadlines or failing to properly identify replacement properties can result in the transaction being treated as a taxable sale.
- Liquidity and Control Limitations: When using structures like Delaware Statutory Trusts (DSTs), investors may gain diversification and passive management, but also give up direct control over real estate decisions. DSTs are generally illiquid and subject to holding periods.
- Tax Deferral, Not Elimination: While a 1031 exchange defers capital gains and depreciation recapture taxes, these liabilities generally carry forward and become due upon future sale, conversion, or cash-out events. If not managed carefully, this can result in larger tax exposure later.
- Estate Planning Assumptions: Although a step-up in basis may eliminate deferred gains for heirs, this benefit depends on prevailing tax law at the time of death, which is subject to change. Relying solely on current provisions may expose heirs to unexpected tax outcomes.
Wrapping Up: How 1031 Exchanges Can Help With Succession Planning
Succession planning for family-owned businesses can be complex and often involves navigating complex decisions, particularly when real estate is involved. A 1031 exchange may offer tools to help address these challenges by deferring capital gains taxes and providing flexibility to reposition assets in a way that aligns with long-term goals. You can enjoy other benefits, including easier repositioning of assets, preservation of capital, and a step-up in basis after your passing.
That said, these strategies also come with important considerations and risks, including strict IRS compliance rules, loss of direct control in certain structures, and the potential for deferred taxes to become due in the future. It's essential to weigh these trade-offs carefully.
Whatever the specifics of your 1031 exchange succession planning, make sure to involve your heirs early so they can understand the plan and add their input. Involving your tax advisors and 1031 exchange experts is also good practice to ensure compliance with IRS rules and create the optimal structure.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Article written by: Story Amplify. Story Amplify is a marketing agency that offers services such as copywriting across industries, including financial services, real estate investment services, and miscellaneous small businesses.
Sources:
https://www.americanbar.org/groups/real_property_trust_estate/resources/real-estate/1031-exchange/
