For many clients, concentrated real estate wealth is both a tax puzzle and a legacy opportunity. Two tools dominate the conversation: like-kind exchanges under section 1031 and the basis adjustment at death under section 1014. Used in concert—and with careful attention to title, entity structure, and timing—these rules can minimize lifetime tax friction while positioning heirs for a clean reset.
How does the basis adjustment on real estate assets work in Texas?
Assets included in a decedent’s gross estate generally receive a basis equal to fair market value on the date of death (or the alternate valuation date, if elected) at the time of the decedent’s death. In community property states like Texas, properly characterized community property can receive a full 100% step-up for both halves when one spouse dies, not just the decedent’s half—if title and characterization are in order.
When does a step-up occur, and what are the implications for heirs?
If real estate is held through a partnership or multi-member LLC taxed as a partnership, heirs inherit an interest in the entity. A step-up occurs on the outside basis of that interest.
Still, the property’s inside basis does not change unless the partnership makes a section 754 election, producing a section 743(b) adjustment that “pushes down” the step-up for the inheriting partner. Without the election, heirs may face depreciation and gain calculations that don’t reflect the property’s current value.
How do section 1031 exchanges interact with the step-up in basis?
A properly executed 1031 exchange defers recognition of gain and depreciation recapture when the taxpayer swaps investment real estate for like-kind property. If the taxpayer later dies holding the replacement property, the deferred gain is generally eliminated by the 1014 step-up—often called “swap ’til you drop.” This includes the recapture potential embedded in the property’s basis; the step-up resets the basis to fair market value, wiping out prior depreciation history.
We have to consider two important caveats.
Installment sale obligations are income in respect of a decedent (IRD), so results may vary under these two differing circumstances.
- If a client sells on the installment method and dies before collecting, heirs generally recognize the remaining gain as payments are received; there is no step-up on the note itself.
- If property has been transferred to an irrevocable trust that is excluded from the decedent’s estate, there may be no step-up—by design. Remember to verify the trust structure before assuming a reset.
A client’s age, objectives, and state of residence determine whether we emphasize the exchange or the step-up.
For Older Clients
For older clients with highly appreciated rental properties who want simplicity and stable cash flow, section 1031 can consolidate “toothpick” properties into fewer, higher-quality assets with professional management and better debt terms, then hold them through death for a basis reset. The exchange improves cash flow; the eventual step-up removes the decades of deferred gain.
For Younger Business Owners
Growth-oriented owners are still building. Exchanges can upsize and reposition, for example, into assets with stronger rental rolls or better markets without triggering taxation. The step-up remains a backstop if assets are ultimately held until death.
For Surviving Spouses
In planning for a surviving spouse in Texas and other community property states, confirm community characterization and titling to capture the 100% step-up potential at first death; avoid inadvertent separate property treatment or titling that fractures the step-up.
Pitfalls tax professionals should watch out for.
“Drop-and-Swap” Near a Sale
Converting a partnership-held property to tenant-in-common interests shortly before an exchange (to allow partners to go their separate ways) risks step-transaction challenges. Build in holding periods and a genuine business purpose.
Related-Party Traps
Exchanges involving related parties are subject to a two-year hold rule and additional scrutiny. Premature dispositions can unwind deferral.
Entity vs. Asset Ownership
Clients often believe they “own the building,” but their return shows a partnership K-1. Map ownership carefully; plan for a section 754 election so heirs can actually depreciate the stepped-up value.
Installment Notes at Death
Remind clients that installment notes are IRD; if liquidity is the goal, consider alternatives to installment structures late in life.
Irrevocable Trust Surprises
A gifted property sitting outside the taxable estate will not receive the step-up. If the long-term plan depends on a basis reset, confirm that the asset will be includible (or rethink the structure).
Debt and Estate Liquidity
A section 1031 exchange can improve leverage but may complicate liquidity for estate tax or equalization among heirs. Coordinate with buy-sell terms, life insurance, or a liquidity sleeve.
Here’s a quick checklist for tax professionals.
- Basis Audit: Document original and adjusted basis, accumulated depreciation, and current FMV for each property; flag partnership-held assets.
- Title & Characterization: In community property states, confirm community status and survivorship agreements; in separate property jurisdictions, verify Joint Tenancy with Rights of Survivorship (JTWROS) vs. tenants-in-common.
- Entity Readiness: If partnerships are involved, prepare a standing section 754 election policy and educate heirs on how a section 743(b) adjustment works.
- Exchange Pipeline: For clients targeting exchanges, line up qualified intermediaries, identify potential replacement assets early, and plan for timing risk.
- Estate Alignment: Ensure revocable trusts are properly funded (step-up preserved) and review any irrevocable trusts to avoid unintended loss of basis adjustment.
The bottom line is that section 1031 exchanges and the estate step-up are not either/or choices.
With disciplined coordination, 1031 exchanges can enhance cash flow and portfolio quality during life, while the step-up removes historical tax friction for heirs. Tax professionals who accurately map ownership, anticipate elections, and align estate plans can unlock both advantages.
Schedule a discovery call, and we’ll talk about current clients who would benefit the most from real estate planning strategies, as well as the specific steps we take to make partnerships easy and highly valuable for the growth of your practice.
– Justin Baker, JD, LL.M., MBA
Advanced Estate Planning Attorney, Baker Wealth Strategies
