How the Stepped-up Basis Compliments a 1031 Exchange

Stepped-up basis is a tax term that refers to adjusting the value of an inherited asset for tax purposes. Specifically, it means resetting the cost basis of an asset to its fair market value (FMV) at the time of the original owner's death.

For example, your mother bought a house 20 years ago for $150,000. When she passes away, you inherit the house, and the house is now worth $500,000 (FMV).

Your cost basis in the property becomes $500,000. If you were to sell the house for $500,000 shortly after inheriting it, you would owe no capital gains tax. If you were to hold it longer and sell it for $550,000, you would only be responsible for taxes on your $50,000 gain.

Compare that to - if your mom were to gift you the house while alive, you would receive her original basis of $150,000. But, if you were to sell the house for $500,000, you would instead owe tax on $350,000.

This can mean waiting to inherit, rather than receiving a gift during life, can be much more favorable for taxes.

Combining stepped-up basis with a 1031 Exchange brings together two major tax strategies in real estate. Here's a clear breakdown of how they interact:

A 1031 exchange (under IRS Code §1031) lets you defer paying capital gains taxes when you sell investment or business real estate and reinvest the proceeds into a “like-kind” property. You defer taxes, but your original cost basis carries over into the new property. You do not eliminate taxes — you simply postpone paying taxes.

When the owner of a property acquired through a 1031 exchange dies, their heirs receive a stepped-up basis — just like with any other appreciated asset. The key point to remember here is that death wipes out the deferred capital gains.

Lets walk through an example:
Let’s say that the owner originally purchased the property for $200,000. They later exchanged, via 103, into another property worth $600,000. The basis from the original property ($200,000) carries over.

Before the owner/taxpayer were to die, the property appreciates to $800,000. That owner has $600,000 in deferred capital gains ($800K - $200K basis).

Upon the owner’s/taxpayer’s death, their heirs will inherit the property with a stepped-up basis of $800,000 (FMV at death). If the heirs sell the inherited property for $800,000: there would be no capital gains tax.

Even though the original owner used a 1031 exchange to defer taxes, those taxes are completely wiped out at death through the step-up. Therefore, some taxpayers plan to hold properties until death to give their heirs a stepped-up basis and avoid ever paying the deferred taxes.

This can be a complicated strategy, so please consult with your tax professional as to how you would need to structure the ownership of the property and how your heirs can receive the stepped-up basis upon death.