Inherited a rental? You probably do not need a 1031 exchange.

What the step-up actually does

Section 1014 provides that property acquired from a decedent generally takes a basis equal to its fair market value on the date of death. Two consequences follow, and the second one surprises people.

• Lifetime appreciation escapes income tax permanently. If your father bought the house for $40,000 in 1978 and it was worth $760,000 when he died, your basis is $760,000. That $720,000 of gain is never taxed to anyone.
• His depreciation disappears too. Forty-odd years of depreciation deductions, which would have produced a large recapture bill had he sold, simply vanish. You inherit no recapture exposure from his ownership period.

There is a third benefit that gets missed. Your depreciation schedule starts over on the stepped-up basis. On a $760,000 property with, say, $560,000 allocated to the building, you now have roughly $20,364 a year of fresh depreciation to shelter the rental income. The property that had run out of depreciation for your father is a tax shelter again for you.

And under Section 1223, your holding period is automatically long-term. Sell a month after inheriting and any gain is still long-term capital gain.

The arithmetic, side by side

Same property, two owners, entirely different outcomes.

The father needed a 1031 exchange. You almost certainly do not. Selling costs you nothing in tax and gives you full liquidity, complete flexibility, and no lockup, no sponsor, and no fees.

Illustration using top-bracket California assumptions, assuming a sale at close to the date-of-death value.

The first thing to do

Before you list the property, before you talk to an advisor, and certainly before you sign anything:

Two related items to check while you are at it:

• Which valuation date was used. Some estates elect the alternate valuation date, six months after death, if it reduces the estate tax. If that election was made, your basis follows it.
• How the property was reported. If a federal estate tax return was filed, the value reported on it is generally binding on you under the consistent basis reporting rules. Get a copy of Form 8971 or Schedule A if one was issued.

When an exchange does make sense

Three situations where inherited property genuinely warrants a 1031 conversation.

• You have held it for years. If you inherited in 2010 and the property has doubled since, you now have real appreciation above your stepped-up basis, plus fifteen years of your own depreciation to recapture. The step-up did its work; you have simply accumulated a new gain on top of it.
• The property was distributed at a low value. Complex estates sometimes report values that are well below current market, particularly where discounts were applied to fractional interests. Your basis is that reported value, not today's price.
• You inherited from a spouse in a common law state, some time ago. Only the decedent's half stepped up. Your original half retains its old basis and its accumulated depreciation, so a substantial gain may exist on that portion.

In all three the honest test is the same one that applies to anybody: run the number. If the tax is under roughly $50,000, the fees and lockup of an exchange rarely justify themselves. If it is $200,000, the conversation is worth having.

If you inherited from a spouse

This is where the geography of your marriage matters more than anything else, and where we see the most expensive misunderstandings.

The difference is frequently worth hundreds of thousands of dollars. It also depends on how title was actually held, whether a community property agreement or a community property with right of survivorship designation was in place, and whether the property was ever moved between states. Confirm it with a local estate attorney rather than assuming, in either direction.

When several people inherited together

Three siblings inherit a rental. One wants cash, one wants to keep collecting rent, one wants passive income without the work. This is common and it is solvable, but only with advance planning.

The governing constraint is the same taxpayer rule: whoever sells must be whoever buys. That creates a few distinct paths:

• If the property is still in the estate or trust and the estate sells, the estate must acquire any replacement property. Distributions to beneficiaries afterward are a separate matter.
• If it has been distributed as tenants in common, each sibling owns an undivided interest and each can independently choose to take cash, exchange into a property, or exchange into a DST. This is the cleanest structure for divergent goals, and it is one reason distributing as tenants in common rather than into an LLC is often better.
• If it went into an LLC or partnership, the entity is the taxpayer. Individual members cannot go separate ways without a drop and swap, which needs to happen well before any sale and requires a tax attorney.

The mistake to avoid is deciding the structure during escrow. If siblings want different outcomes, that conversation belongs a year before the listing, not a week before closing.

Worth noting: with a full step-up, most of this is easier than it sounds, because there may be little tax at stake for anyone. The disagreement is usually about the property, not the taxes.

Should you keep it instead?

A step-up hands you something valuable that people often overlook: a fresh depreciation schedule on a high basis.

Your parent's property had run out of depreciation decades ago, so every dollar of rent was fully taxable to them. Your version starts over. On a $760,000 property with $560,000 of building value, you have roughly $20,000 a year of depreciation deductions against the rental income. For many inherited rentals, that shelters most or all of the cash flow.

So the honest set of choices looks like this:

• Sell now. Little or no tax, full liquidity, no complexity. Often the right answer.
• Keep it and rent it. A newly tax-efficient asset, if you are willing to be a landlord.
• Sell and reinvest in whatever you want. With no tax bill, you are not confined to real estate. Index funds, a business, anything.
• 1031 exchange. Only if the numbers say you have a real gain to defer.

Notice that three of those four do not involve us. That is the point of this page.