You Inherited a Rental. You May Have Nothing Left to Defer

When someone inherits a rental property and then decides to sell it, the instinct is to arrange a 1031 exchange quickly, before some deadline is missed.

Often that instinct is wrong, and the reason is good news. Property owned at death generally receives a basis adjustment to fair market value. For an heir selling soon afterwards, there may be almost no gain left to defer.

What happens to basis at death?

The basis of property acquired from a decedent is generally adjusted to its fair market value at the date of death, or at an alternate valuation date where that election is made.

For property the deceased had owned for decades, that adjustment can be dramatic. A rental bought for 180,000 dollars in 1994, depreciated for thirty years down to an adjusted basis of perhaps 60,000 dollars, and worth 900,000 dollars at death, generally passes to heirs with a basis near 900,000 dollars.

The deferred gain and the accumulated depreciation recapture that would have been taxed on a sale during life are generally eliminated.

What does that mean if you sell?

If the heir sells for close to the date of death value, the taxable gain is small, sometimes negligible. Selling costs can even produce a loss.

In that situation a 1031 exchange achieves very little. It imposes 45 and 180 day deadlines, requires a Qualified Intermediary, and forces the purchase of replacement property, all to defer a gain that is barely there.

Heirs who want to keep real estate can simply buy what they want, when they want, without any of those constraints.

When might an exchange still make sense for an heir?

Time has passed. If the property has appreciated significantly since the date of death, or the heir has held and depreciated it for years, a real gain may have accumulated.

The estate held it for a long period. Values move between death and sale.

The heir wants to stay invested anyway. Even a modest deferral is worth something if you intended to buy replacement property regardless.

There is debt. Debt relief can create taxable amounts even where the gain is small.

What do heirs actually need to do?

Establish the date of death value properly. This is the single most important step. An appraisal as at the date of death supports the new basis. Without evidence, an heir may struggle to prove basis and could pay tax unnecessarily.

Fix depreciation. Depreciation on inherited property generally restarts from the new basis over a fresh recovery period, rather than continuing the deceased's schedule.

Check community property rules. In community property states, a surviving spouse may receive an adjustment on both halves of community property at the first death, which is more generous than the treatment of jointly held property elsewhere.

Understand the estate's own position. Estate tax is a separate question from income tax, and larger estates have their own planning considerations.

What about property inherited by several heirs?

Co owners each take their share with an adjusted basis. Each can decide independently whether to sell or keep, and each is a separate taxpayer for exchange purposes if an exchange is used.

Practical disagreements are common, and they are about the property rather than the tax. One heir wanting to keep a building and another wanting cash usually leads to a buyout or a sale.

What is the most common mistake?

Rushing into an exchange without calculating the gain first. The deadlines create urgency, and advisers who assume an exchange is always desirable can reinforce it.

The second most common is failing to obtain a date of death appraisal. Years later, when the property is sold, reconstructing that value is difficult and the heir may end up accepting a lower basis than they were entitled to.

What should a surviving spouse know?

The rules differ depending on how title was held and whether you live in a community property state. Because the difference can be worth a great deal, it is worth confirming early rather than assuming the treatment is the same as for other heirs.

What to do first

Before anyone mentions deadlines, ask your CPA for one number: the estimated gain if you sold today, using the date of death value as basis. If that number is small, an exchange is probably unnecessary. If you have not obtained a date of death appraisal, arrange one now, whatever you intend to do with the property.

Nothing here is tax, legal or investment advice. Basis and estate rules are technical and change over time. Confirm your position with your CPA and estate attorney.