If You Inherit a DST, Can You 1031 Exchange Out of It Later?

Worked example: a $2,000,000 DST share inherited at $2,400,000 and sold two years later for $2,500,000

Hypothetical, round numbers. A parent bought a rental decades ago for $400,000, depreciated the building to nothing and exchanged it at $2,000,000 into a DST, carrying a $100,000 basis and $1,900,000 of deferred gain. The parent dies when the DST share is worth $2,400,000, so under §1014(a) the heir's basis becomes $2,400,000 and the $1,900,000 of deferred gain and the parent's depreciation recapture disappear.

The heir depreciates the stepped-up building basis for two years, say $60,000, leaving a $2,340,000 basis when the trust sells and the heir's share of net proceeds is $2,500,000. Gain is $160,000: $60,000 of unrecaptured §1250 gain taxed at up to 25% and $100,000 taxed at up to 20%, plus 3.8% net investment income tax if income exceeds the §1411 threshold, roughly $41,000 in all.

That $41,000 is what a new exchange would defer. Against it, a replacement DST's up-front load on $2,500,000 of equity at the 7% to 12% ranges industry sources cite would be $175,000 to $300,000, so after a step-up the tax is often the cheaper door. Run both numbers with your CPA before you commit the proceeds to another trust.

You can exchange because the heir becomes a grantor of the trust and owns the real estate, not a trust certificate

Rev. Rul. 2004-86 holds that a person who acquires an interest in the trust from a grantor is treated as a grantor under Reg. §1.671-2(e)(3) and is 'considered to own an undivided fractional interest in' the property for federal income tax purposes. An heir who takes the interest from the decedent steps into that position, reports the rents on Schedule E from the sponsor's grantor statement and, at sale, is selling real estate rather than a beneficial interest excluded by §1031(a)(2).

The same section 1031 mechanics then apply: a written exchange agreement with a qualified intermediary before the trust's closing, assignment of your rights to the intermediary with written notice to the parties on or before the transfer, and no right to receive or borrow against the money during the exchange period (Reg. §1.1031(k)-1(g)(4) and (g)(6)). The 45-day identification and 180-day receipt deadlines run from the day the trust's property closes, not from when a check would have arrived.

Holding period is not an obstacle. Under §1223(9), property acquired from a decedent is treated as held for more than one year even if sold within a year of death, and the 'held for investment' test in §1031(a)(1) looks at your purpose, which an income-producing interest you keep until the sponsor sells generally satisfies.

Three exits after the step-up: cash out, exchange into new trusts or direct property, or accept a 721 roll-up

The decisive variable is the size of the post-death gain. With a large gain (a long hold after death or fast appreciation) an exchange earns its cost; with a small one the load and illiquidity of a replacement DST exceed the tax deferred.

• Cash out: pay tax only on post-death appreciation and depreciation, as in the example, and walk away with liquid funds and no further exchange obligations.
• Exchange into other DSTs: preserves deferral of the small gain but costs a new load and restarts an illiquid hold; sensible mainly when the gain since death is large or state tax is high.
• Exchange up into direct property: add your own cash to the exchange proceeds and buy a building you control; the exchange still has to satisfy the like-kind and holding rules in the eligibility requirements.
• Accept a 721 contribution if the sponsor offers one: this is not a 1031 and ends future exchanges, but it converts the interest into REIT operating-partnership units (DST to 721).

Several heirs, one fractional interest: split it before the sale so each heir can elect independently

A DST interest can be divided among heirs into separate beneficial interests, which is one reason estate planners like the structure; once divided, each heir is a separate owner who makes a separate cash-or-exchange election when the trust sells, with no partnership vote to win. Sponsors may enforce a minimum interest size, so confirm early that the estate's share can be split the way the will directs.

If the estate still holds the undivided interest when the property closes, the estate is the taxpayer: it either exchanges for everyone or cashes out for everyone, and heirs who wanted a different result have no separate election. Executors should therefore finish the retitling (transfer paperwork) well before the sponsor's sale notice.

Heirs who all want to exchange can still choose different replacement property; nothing requires them to move together, and each has their own 45-day list and 180-day deadline.

Executor's timeline: valuation in the first weeks, retitling before the sale notice, intermediary before the closing

The sponsor controls when the property sells and the heirs control nothing about that date, so the estate's work has to be finished before the notice arrives.

• Weeks 1 to 8: obtain a date-of-death fair market value for the interest and, if a Form 706 is required, plan the Form 8971 Schedule A that will fix each heir's basis under §1014(f).
• Before any sale notice: submit the sponsor's transfer package so distribution and closing paperwork reach the heirs, not the decedent's closed account.
• When the sponsor announces a sale: each heir who wants to exchange engages a qualified intermediary and signs the exchange agreement before the closing date; proceeds go from the closing to the intermediary.
• At closing: watch for state withholding on nonresident sellers, which is a prepayment claimed on that state's return (multi-state issues).
• Days 1 to 45 and 1 to 180 after closing: identification and receipt deadlines under §1031(a)(3) (deadline guide).
• Year-end: file Form 8824 for each exchange and keep the stepped-up basis computation permanently with it.