A 1031 exchange defers capital gains tax. It does not eliminate it. That distinction matters, because the deferred gain does not just disappear, it carries forward into the replacement property through something called basis. For many investors, though, there is a way that deferred gain can be erased entirely, not through another exchange, but through a step-up in basis at death.
Understanding how these two rules interact, one from Section 1031 and one from Section 1014 of the Internal Revenue Code, is often the difference between a good tax deferral strategy and a great estate planning one.
What Is a Step-Up in Basis?
A step-up in basis is a tax rule under IRC Section 1014 that resets an asset's tax basis to its fair market value on the date of the owner's death. Instead of a beneficiary inheriting the original owner's cost basis, they inherit the property at its current market value. If the property is sold shortly after at close to that value, there is little or no capital gain to tax.
Basis, in simple terms, is what the IRS treats as your cost in a property. It starts as the purchase price, gets reduced by depreciation taken over the years, and gets increased by capital improvements. The lower the basis, the larger the taxable gain when the property is sold. A step-up resets that number for the next generation.
How Does a 1031 Exchange Affect an Investor's Basis?
A 1031 exchange lets an investor defer tax on the gain from selling investment property by reinvesting the proceeds into replacement property, but the original basis does not go away. It carries over into the new property, adjusted for any additional cash invested or debt taken on.
This is why investors who exchange repeatedly over a career often end up with a very low basis relative to the current value of what they hold. Each exchange preserves the deferral, but it also keeps stacking built-in gain onto that same, shrinking basis. Eventually, that gain has to be dealt with, either through a taxable sale or through the investor's estate.
Key Point: A 1031 exchange defers the tax bill. It does not reduce the size of the gain waiting to be taxed.
What Happens When a Step-Up in Basis Meets a 1031 Exchange?
When an investor holds 1031 replacement property (or a fractional interest such as a Delaware Statutory Trust) until death, the low, carried-over basis is stepped up to fair market value at that point. The capital gains and depreciation recapture that had built up across a lifetime of exchanges are not passed on to the heirs. In most cases, they are simply never taxed.
This is often referred to informally as "swap till you drop." The investor keeps exchanging into new properties to defer tax during their lifetime, and the step-up at death does the rest.
Here is an example. An investor originally bought a property for $500,000 and completed several 1031 exchanges over the following 25 years. By the time of their death, depreciation and rolled-over gain from prior sales have brought the adjusted basis down to $150,000, even though the replacement property is now worth $1,200,000. Under current law, the heirs' basis becomes $1,200,000. If they sell shortly after for close to that value, there is little or no capital gains tax due on the $1,050,000 of gain that had built up over the investor's lifetime.
Key Point: The step-up applies at death, not during the investor's lifetime. Gifting a 1031 replacement property to an heir while you are still living does not trigger a step-up. The recipient inherits your original, lower basis instead.
Does a Step-Up in Basis Apply to DST Interests?
Yes. A step-up in basis applies to beneficial interests in a Delaware Statutory Trust (DST) and to tenant-in-common (TIC) interests in the same way it applies to direct property ownership. This is one of the reasons DSTs come up often in estate planning conversations. An investor who no longer wants to manage property directly can complete a 1031 exchange into a DST, continue deferring tax, and still preserve the step-up benefit for their heirs down the line.
When Might This Strategy Make Sense?
A swap till you drop approach is not the right fit for every investor, and it depends heavily on individual estate planning goals, health, family circumstances, and how the investor's overall estate is structured. It tends to come up in conversations where an investor:
Wants to keep deferring tax during their lifetime rather than realize a large gain now
Is thinking about how to pass real estate wealth to the next generation with less of a tax burden attached
Is interested in moving from actively managed property into a more passive structure, such as a DST, without giving up the deferral already built up
Has appreciated real estate they intend to hold long term rather than sell
Proper estate planning documents, such as a will, trust, or beneficiary designation, still need to be in place for the transfer to work the way it is intended. An estate planning attorney and CPA should be involved well before this becomes a factor, not after.
Key Point: A step-up in basis is a feature of current tax law, and tax law can change. Investors relying on this strategy should revisit their plan periodically with their tax and legal advisors.
Key Takeaways
A step-up in basis resets an inherited asset's tax basis to its fair market value at the date of death, under IRC Section 1014
A 1031 exchange defers gain by carrying the original basis forward into new property, it does not erase it
Combining the two, often called "swap till you drop," can allow deferred gain and depreciation recapture built up over a lifetime of exchanges to go untaxed for heirs
The step-up applies only at death, not to properties gifted during the owner's lifetime
DST and TIC interests qualify for the same step-up treatment as direct property ownership
This is an estate planning strategy, not a guarantee, and should be reviewed with a tax advisor and estate planning attorney
FAQ
Q1: What is a step-up in basis? A1: A step-up in basis is a rule under IRC Section 1014 that resets an inherited asset's tax basis to its fair market value on the date of the original owner's death, rather than carrying forward the decedent's original cost basis.
Q2: How does a step-up in basis work with a 1031 exchange? A2: A 1031 exchange defers tax by carrying an investor's original basis forward into replacement property. If that property is held until death, the carried-over basis can be stepped up to fair market value, which may eliminate the deferred capital gains tax and depreciation recapture that had accumulated over the investor's lifetime.
Q3: Does depreciation recapture go away with a step-up in basis? A3: In most cases, yes. Because the basis resets to fair market value at death, the depreciation recapture liability tied to the old, lower basis is generally not passed on to the heir.
Q4: Does a step-up in basis apply to DST interests? A4: Yes. A step-up in basis applies to fractional interests in a Delaware Statutory Trust (DST) and to tenant-in-common (TIC) interests, the same way it applies to directly owned real estate.
Q5: What does "swap till you drop" mean? A5: It is an informal term for a strategy where an investor continues completing 1031 exchanges throughout their lifetime to defer tax, with the intention of holding the final replacement property until death so that heirs receive a step-up in basis.
For more information, please contact our team at info@firstguardiangroup.com or download our eBook:
Your Comments :