Real Estate Investment Properties in Estates: 1031 Exchanges and Step-Up Basis

When a decedent's estate includes investment real estate, the executor faces a compounding set of technical requirements. The basis step-up under IRC Section 1014(a) can create enormous tax savings for heirs, but only if you understand precisely when it applies, what gets stepped up, and what remains at carryover basis. Add depreciation recapture, pending 1031 exchanges, partnership interests, and joint tenancy complications, and you've entered the terrain where an error costs heirs tens of thousands in unnecessary capital gains tax.

This article walks through the mechanics, exceptions, and executor duties for managing investment real estate in estate settlement.

The Basis Step-Up at Death: How It Works for Rental Properties

Under IRC Section 1014(a), property acquired from a decedent receives a basis adjustment equal to the property's fair market value as of the date of death (or, if elected, the alternate valuation date six months later). For heirs inheriting rental property, this rule creates a powerful tax reset.

Consider a concrete example: Your decedent owned a rental duplex purchased 20 years ago for $200,000. Over those decades, she claimed $130,000 in depreciation deductions, reducing her adjusted basis to $70,000. At date of death, the duplex is worth $450,000. Under Section 1014(a), the heir's new basis is $450,000, not $70,000. If the heir immediately sells the property for $450,000, there is zero taxable gain. The $130,000 in accumulated depreciation, which was deducted dollar-for-dollar against ordinary income, effectively vanishes from a tax perspective.

This is a massive benefit. In a high-income state like California, New York, or Illinois where combined state and federal tax rates exceed 50%, the tax savings on $130,000 of stepped-up value can exceed $65,000. That money stays in the estate and available for heirs.

The step-up applies at the moment of death. It does not require the heir to take any affirmative action. The basis adjustment happens automatically under federal tax law. However, the executor's job is to document it properly: obtain a qualified appraisal of the property's fair market value as of the date of death, and ensure that value is reported on the estate's federal Form 706 (if filed) and communicated to the heir so that the heir knows the new basis for future sales.

The Section 1014(a) basis step-up applies to virtually all property acquired from a decedent: real property, personal property, securities, partnership interests, mineral interests, even artwork and jewelry. For investment real estate, it is the rule that makes the difference between manageable tax outcomes and unexpected capital gains taxes years later.

When Step-Up Does NOT Apply: The Section 1014(e) Exception

The Section 1014(e) anti-abuse rule denies the basis step-up in a specific, narrow scenario. If the decedent acquired property from another person within one year of the decedent's death, and the other person's estate (or beneficiary) later received the same property back, the basis does not step up to fair market value. Instead, it carries over at the original basis.

This rule targets flip-and-die schemes: Grandpa owns real estate with low basis. He gifts it to Junior, who immediately holds it briefly, then transfers it back to Grandpa to be reacquired for a higher basis. If Grandpa dies within the one-year window, Section 1014(e) says no, the basis reverts to the original lower amount, defeating the strategy.

For estates with investment real estate, Section 1014(e) rarely applies. The typical scenario involves a recent acquisition by the decedent within one year of death, followed by the death, followed by the property going to the person from whom the decedent acquired it. If you encounter investment property that the decedent purchased recently, ask: did the decedent acquire this from someone currently claiming an interest in the estate? If yes, Section 1014(e) may apply.

When it does apply, the practical impact is that step-up is denied and the heir takes the property at the decedent's carryover basis. This means the executor must know the decedent's cost basis in that property, document it carefully, and disclose it to the heir.

Depreciation Recapture: What Steps Up and What Doesn't

This is the critical nuance that trips up many professionals. Under IRC Section 1250(c), the step-up applies to the property itself, but depreciation recapture on that property does NOT step up.

Here's what happens: The depreciable building portion of real estate steps up to fair market value at death. That part works as expected. But if the heir subsequently sells that property at a gain, the heir faces depreciation recapture tax on the "additional depreciation" deducted during the decedent's ownership. This is taxed at Section 1250(c) rates: 25% for real property depreciation under Section 1250, plus ordinary income rates on any excess depreciation.

In practice, for most residential and commercial rental property, the recapture rate is 25% on the depreciation deducted post-1986. This is lower than the regular capital gains rate, which is helpful. But it means the heir cannot completely escape the tax consequences of the decedent's depreciation claims.

The math: Decedent bought a rental property for $300,000. Building value: $250,000; land: $50,000. Over 30 years, decedent claimed $200,000 in building depreciation. Adjusted basis at death: $100,000. Fair market value at death: $500,000.

Heir receives property with new basis of $500,000 (full step-up). But if heir sells immediately for $500,000, the heir owes zero capital gains tax on the appreciation ($500,000 FMV minus $100,000 adjusted basis). However, the heir owes depreciation recapture tax on the $200,000 in depreciation that the decedent claimed. At 25%, that's $50,000 in recapture tax (not counting any state taxes).

Why? The IRS reasons that depreciation deductions saved the decedent $50,000+ in ordinary income tax over the years (at ordinary rates ~35%). The recapture tax at 25% is the government's partial claw-back of that benefit. The heir does not get to claim the depreciation benefit and also walk away tax-free.

The executor's duty here is critical: at the date-of-death appraisal, segregate the land value from the building value. Know exactly what depreciation the decedent claimed on that property. Calculate the depreciation recapture exposure and disclose it to the heir. Many heirs are shocked to learn they owe $40,000 in depreciation recapture tax after inheriting property they thought stepped up to full fair market value. This disclosure, done early, allows the heir to plan for the tax liability and understand the true after-tax economics of keeping or selling the property.

1031 Exchanges and the Death of the Property Owner

A 1031 exchange, under IRC Section 1031, allows a taxpayer to defer capital gains tax on real property by exchanging it for like-kind property within tight timeframes: identify replacement property within 45 days of relinquishing the original property, and close on the replacement property within 180 days.

If the decedent died mid-exchange (after relinquishing the original property but before acquiring the replacement), what happens? Can the estate or the executor complete the exchange?

The answer is: probably not, and the issue is highly fact-specific. The IRS has issued private letter rulings both allowing and disallowing exchange continuation by estates. The risk is that the decedent's death breaks the chain of intent required for a valid Section 1031 exchange, and the relinquished property is treated as a taxable sale.

However, several states and some revenue procedures have suggested that if an executor acts with authority to carry out the decedent's intent, and if the timeline is still within the 180-day window, the exchange can be completed and the deferral preserved. This is not guaranteed and depends on facts and circumstances: the decedent's documented intent, the executor's authority under the will or trust, the timeliness of the executor's actions, and the specific mechanics of the exchange.

Practical scenario: Decedent owned a commercial office building held in a Delaware Statutory Trust as part of a 1031 exchange program. The decedent passed away 60 days into the 180-day acquisition window. The executor has clear authority in the will to continue the exchange, and the replacement property is already identified. The exchange intermediary (a qualified intermediary under Section 1031 regulations) is willing to work with the estate. The executor petitions the probate court for authority to complete the acquisition within the remaining time window and consummates the deal.

If structured carefully, the IRS may respect the deferral. If done sloppily (executor dawdles, loses track of the timeline, or acts without clear authority), the IRS will treat the relinquished property as a taxable sale to the estate, triggering capital gains tax.

For executors managing investment real estate, the first step is to identify any pending 1031 exchanges. Ask the decedent's CPA, real estate advisor, and accountant. If one exists, immediately contact the qualified intermediary, verify the timeline, document the decedent's intent, and seek probate court authorization before taking any action. This is a case where 30 days of delay can be fatal.

Basis Step-Up Timing and Alternate Valuation Date Election

The basis step-up is calculated using the property's fair market value as of the decedent's date of death. If the estate elects the alternate valuation date (six months after death), the basis is the fair market value on that date instead.

The alternate valuation date election is available only if two conditions are met: (1) the estate's gross estate exceeds the current filing threshold (2026: $13.61 million), and (2) the election reduces both the gross estate and the estate tax liability. Most estates do not meet this threshold, so the date-of-death valuation is the standard.

For investment real estate, the valuation date matters enormously. If the property's value swings significantly between date of death and six months later, the executor should consider whether the alternate valuation date would lower the stepped-up basis (and thus save the estate and heirs money on future gains). A declining market may make the alternate date attractive; a rising market would not.

Fair market value is defined as the price at which the property would change hands between a willing buyer and willing seller, neither under compulsion and both having reasonable knowledge of relevant facts. This is not the appraised value for insurance purposes, or the assessed value for property tax purposes. It requires a qualified appraisal by a professional appraiser.

The executor's duty is to obtain an independent, written appraisal of each investment real estate property as of the date of death (and, if applicable, as of the alternate valuation date if that election is considered). This appraisal becomes the basis documentation for the estate's tax filings and for communication to heirs.

Depreciable Real Estate: Bonus Depreciation Considerations

Under IRC Section 168(k)(2)(B), the Tax Cuts and Jobs Act introduced bonus depreciation for qualified property. If the decedent was still actively depreciating property under Section 168, and the estate continues that depreciation, the executor must track cost recovery allocations carefully.

Bonus depreciation applies to qualified property placed in service after September 27, 2017, and the percentage has been phased down in recent years. In 2026, bonus depreciation is 60% (declining annually until it phases out entirely after 2032).

For estates, the issue is this: if the decedent took bonus depreciation on a property in the year of death, and the property steps up in basis, does the estate continue bonus depreciation on the stepped-up basis, or does the depreciation clock reset? The answer depends on whether the property qualifies as "qualified property" in the hands of the estate, and whether the estate's cost basis is treated as a new acquisition.

In practice, if the decedent was depreciating property under Section 168 and bonus depreciation, the executor should work with the estate's CPA to determine the allocation between land and building, the applicable depreciation method, and whether bonus depreciation continues post-death. This is technical and often requires a cost segregation analysis if the property was recently acquired and subject to bonus depreciation.

Installment Sale Contracts and No Step-Up

Under IRC Section 1014(c), property acquired by the decedent under an installment sale contract does NOT receive a step-up in basis to fair market value. Instead, the basis remains at the adjusted basis at the time of death, and the heir inherits the decedent's position in the contract.

This rule is narrow but important. It applies when the decedent contracted to acquire property but had not yet completed payment. Example: Decedent agreed to buy a commercial warehouse from a neighbor under a 10-year installment note. The decedent made five years of payments and then died. The FMV of the warehouse is now $500,000, but the decedent's adjusted basis (cost paid plus improvements) is only $200,000. Section 1014(c) says the heir takes the property at $200,000 basis, not $500,000.

Why? The IRS treats the installment contract as a "carved-out" transaction. The decedent had an unsatisfied obligation (the remaining installment payments), and the step-up is denied to prevent erosion of the decedent's estate tax base. The heir still owes the remaining payments, and the heir will have ordinary gain on the remaining installment income as payments are made (if the contract is structured as an installment sale and qualifies for installment reporting).

Mitigation strategies exist: if the estate has liquid assets, the executor can pay off the remaining balance of the installment contract before the heir takes title. This converts it from an "uncompleted" installment sale into a completed purchase, and the heir receives the property with a full step-up basis equal to (cost paid plus remaining balance paid by the estate). The economics depend on whether the decedent's basis is significantly lower than fair market value and whether the estate has enough liquidity.

For executors, the lesson is: identify any real property that the decedent was acquiring on an installment contract. Determine the remaining balance, the decedent's adjusted basis, and the current fair market value. Model the tax consequences of allowing the heir to assume the contract (ordinary gain on installment income) versus paying off the contract from estate assets (cost of liquidity, but clean basis for the heir).

Partnership Real Estate and Basis Step-Up Complexity

When the decedent owned investment real estate through a partnership (general partnership, limited partnership, or LLC taxed as a partnership), the step-up analysis becomes multilayered.

The decedent's partnership interest itself steps up in basis under Section 1014(a). The stepped-up value is the fair market value of the partnership interest at the date of death, not the underlying real estate value. This is an important distinction. A 5% limited partnership interest in a property worth $1 million might have a fair market value of only $300,000 (due to illiquidity discount and passive ownership). The heir's basis in the partnership interest is $300,000, not $50,000 (5% of $1 million).

However, IRC Section 743(b) adds a wrinkle. If the partnership is taxed under Section 754 election (or is required to make that election), then when the heir becomes a partner, the partnership must make an inside basis adjustment equal to the difference between the heir's basis in the partnership interest and the heir's share of the partnership's basis in its assets. This adjustment is tracked under Section 743(b) and allocated to the partnership's properties, with part allocated to the real estate.

In effect, this second step-up allows the heir to benefit from the step-up in the partnership interest, and the partnership adjusts the basis of the underlying real estate proportionately. But this requires that the partnership make a Section 754 election, which many small partnerships have not done.

The executor's duty: if the decedent held any investment real estate through partnership interests, ask the partnership whether it has a Section 754 election in place. If not, consult with the partnership's tax advisor or the partnership's managing partner about making that election. The cost of the election is minimal, but the benefit to the heir can be substantial, especially in properties held for decades with significant appreciation.

Real Estate Held by Tenancy in Common vs. Joint Tenancy

The decedent's ownership structure (sole ownership, tenancy in common, joint tenancy, or tenancy by the entirety) determines what portion of the real estate receives a step-up in basis.

For property held by the decedent and others as tenants in common, the step-up applies only to the decedent's fractional share. If the decedent owned 50% of a rental property as a tenant in common, only the decedent's 50% interest steps up to fair market value. The surviving tenant in common's 50% retains its original basis.

For property held as joint tenancy with right of survivorship, the step-up analysis depends on who the other joint tenant is. If the decedent and spouse held property as joint tenants (which is the default in community property states for married couples), IRC Section 2040(b) provides that only 50% of the property receives a step-up in basis. The surviving spouse's 50% retains its original basis (or, more precisely, the spouse's portion already had a step-up when it was acquired, if the acquisition was from third parties, or was never subject to depreciation if the property was the couple's primary residence).

If the decedent held property as joint tenant with someone other than a spouse (e.g., adult child, business partner), IRC Section 2040(a) applies. Absent clear evidence to the contrary, the IRS presumes the entire property value is included in the decedent's gross estate, and 100% of the property steps up in basis for the surviving joint tenants. This is a favorable rule for non-spouse joint tenants, but it also means the entire value is subject to estate tax in the decedent's estate.

The executor's documentation must clearly reflect the ownership structure at death and the percentage step-up for each property. For joint tenancies, the executor should obtain a quit claim deed from the surviving joint tenant confirming that the property passes outside of probate and documenting the surviving tenant's intent to rely on Section 2040 (either 2040(a) or 2040(b), depending on the relationship).

IRC Section 121 Exclusion and Primary Residence

If the decedent owned investment real estate but also owned a primary residence, the heir may be able to claim the Section 121 primary residence exclusion on sale. This section allows individual taxpayers to exclude up to $250,000 of capital gains (or $500,000 if married filing jointly) on the sale of a primary residence, provided the taxpayer owned and lived in the residence for at least two of the five years before the sale.

An heir who inherits the decedent's primary residence and sells it shortly after the decedent's death may be able to claim the Section 121 exclusion. The requirement is that the heir meet the ownership and use test, which is often satisfied by the decedent's ownership and use prior to death, combined with the heir's brief ownership after the decedent's death.

Conversely, investment real estate (rental properties, second homes not used as primary residences, commercial buildings) does not qualify for the Section 121 exclusion. An heir who inherits a rental property and sells it will owe capital gains tax on the appreciation above the stepped-up basis.

The implication for executors: when documenting property at the date of death appraisal, clearly distinguish between the decedent's primary residence and investment properties. The primary residence gets special treatment under Section 121, which can save substantial tax for the heir. Investment properties do not, and the executor should model the depreciation recapture and capital gains tax outcomes for the heir's benefit.

FAQ

Q: Does the heir get a step-up in basis on a depreciated rental property?

A: Yes, the heir receives a step-up equal to the property's fair market value at the date of death. This means the heir's basis is the FMV, regardless of the decedent's lower adjusted basis. However, the heir remains liable for depreciation recapture tax (IRC Section 1250(c) at 25% rate) on the depreciation deducted during the decedent's ownership if the heir sells the property. The step-up eliminates capital gains tax on the appreciation, but not the recapture tax on prior depreciation deductions.

Q: Can the estate complete a 1031 exchange that the decedent started but did not finish before death?

A: Possibly, but not guaranteed. The executor can attempt to complete the exchange if the decedent's will or trust grants the executor authority to do so, if the 180-day acquisition window remains open, and if the executor acts promptly. The IRS has issued private letter rulings both allowing and disallowing exchange continuation by estates, so the outcome is fact-specific. The executor should contact the qualified intermediary immediately, document the decedent's intent, seek probate court authorization, and consider filing a private letter ruling request to ensure IRS acceptance.

Q: Does the entire joint tenancy property step up in basis, or only part of it?

A: It depends on the relationship between the joint tenants. If the joint tenants were spouses, only 50% of the property steps up under IRC Section 2040(b); the survivor's 50% retains its original basis. If the joint tenants were not spouses, 100% of the property typically steps up under IRC Section 2040(a), but the entire value is included in the decedent's gross estate for estate tax purposes. The executor must obtain documentation (quit claim deed or similar) from the surviving joint tenant confirming the ownership structure and the applicable Section 2040 rule.

About Afterpath

Afterpath automates the complexities of investment real estate in estate settlement. At intake, Afterpath flags properties held in partnership structures, identifies pending 1031 exchanges, and flags properties with significant accumulated depreciation. Afterpath orders date-of-death fair market value appraisals segregating land and building values. It calculates depreciation recapture exposure, models 1031 exchange continuation timelines, accounts for joint tenancy ownership structures, and generates tax basis schedules for heirs and their CPAs.

The result: executors close estates faster, heirs understand their tax liabilities upfront, and CPAs receive documentation that lets them file accurate tax returns without back-and-forth questions. Afterpath transforms investment real estate from a liability into a manageable workflow.

Authority & Expertise Overlay

Basis Step-Up: IRC Section 1014(a) provides that property acquired from a decedent receives a basis adjustment equal to fair market value at date of death or alternate valuation date, six months after death.

Section 1014(e) Anti-Abuse Exception: Denies step-up if the decedent reacquired property from another person within one year of the decedent's death and the other person's estate or beneficiary subsequently receives it.

Depreciation Recapture: IRC Section 1250(c) requires heirs to recognize depreciation recapture at 25% on real property depreciation deducted post-1986, even though the property receives a full basis step-up. This is a partial claw-back of the decedent's prior depreciation deductions.

1031 Exchange Continuation: IRC Section 1031 allows deferral of capital gains if replacement property is identified within 45 days and acquired within 180 days of relinquishing property. Executor continuations are not guaranteed and depend on facts, executor authority, and timeliness.

Installment Sale Contracts: IRC Section 1014(c) denies basis step-up for property acquired by the decedent under an uncompleted installment sale contract; the heir takes the property at the decedent's carryover basis.

Joint Tenancy Basis Step-Up: IRC Section 2040(b) provides 50% basis step-up for spouses holding property as joint tenants. IRC Section 2040(a) provides 100% basis step-up for non-spouse joint tenants, but the entire value is included in the decedent's gross estate.

Primary Residence Exclusion: IRC Section 121 allows heirs to exclude up to $250,000 of gains (or $500,000 if married filing jointly) on sale of a primary residence if the ownership and use tests are met. This does not apply to investment properties.