Inherited Property in a No-Step-Up Trust: 1031 Strategies to Avoid a Huge Tax Bill

Rev. Rul. 2023-2 leaves a GST or dynasty trust with the grantor's basis, not a date-of-death value

The reset under §1014(a) belongs to property acquired from a decedent, and §1014(b) lists what counts: bequests, revocable trusts, community property and anything else included in the gross estate. A completed gift to an irrevocable trust that the grantor kept out of the estate is on none of those lists, so Rev. Rul. 2023-2 holds that its basis the day after the grantor's death is the same as the day before.

A generation-skipping trust adds a second missed chance. When the trust later ends at a child's death, §2654(a)(2) adjusts basis only in proportion to the inclusion ratio, and a fully exempt trust with an inclusion ratio of zero gets no adjustment at all.

The result is a trust holding a rental with the grandparent's original cost less every year of depreciation since. The trade for that low basis was estate-tax freedom: the building sits outside both the grantor's and the beneficiary's taxable estates, which matters only above the $15,000,000 exclusion in force for 2026.

• Revocable living trusts: stepped up under §1014(b)(2) and (b)(3), because the grantor could amend or revoke.
• QTIP and other marital trusts: stepped up under §1014(b)(10), because §2044 pulls them into the surviving spouse's estate.
• Irrevocable trusts whose assets are nonetheless included in the gross estate: stepped up under §1014(b)(9).
• Completed-gift irrevocable trusts, including GST-exempt dynasty trusts: no adjustment, per Rev. Rul. 2023-2.

Worked example: a $2,000,000 California rental with a $400,000 trust basis owes about $395,800 in federal tax if sold

Assume a hypothetical GST-exempt trust owns a $2,000,000 rental carrying a $400,000 adjusted basis after $300,000 of depreciation, and the trustee sells with no exchange. The gain is $1,600,000: $300,000 of unrecaptured §1250 gain taxed at 25% ($75,000) and $1,300,000 taxed at the 20% rate ($260,000).

A trust hits the 37% bracket and the 3.8% NIIT at just $16,000 of retained income in 2026, so if the gain stays in the trust the NIIT adds $60,800. That is $395,800 of federal tax before selling costs and before California's own tax, which the California page covers.

With a completed exchange the trust reports no gain in the year of sale and the full $2,000,000 of equity keeps working. The tax is deferred rather than erased, because the replacement inherits the $400,000 basis under §1031(d) and the trust still has no reset ahead of it.

The trust is the exchanger: the trustee signs the QI agreement and title to the replacement stays in the trust

An irrevocable non-grantor trust is a taxpayer with its own EIN, so the trust, acting through its trustee, is the party that sells, identifies and buys. The qualified intermediary agreement, the 45-day identification letter and the replacement deed all carry the trust's name, and deeding the property to a beneficiary before the sale would change the taxpayer and break the exchange; the same-taxpayer guide covers that line.

The deadlines are the ordinary ones: 45 days to identify and 180 days to close under §1031(a)(3), with the 180 days cut short by the trust's Form 1041 due date unless the trustee files an extension. A trust that closes late in the year should calendar that extension on day one; the deadline traps guide explains the straddle.

Trust instruments rarely mention exchanges, so the trustee should confirm the document permits reinvestment in real property and in passive securities before the exchange opens. Where the investment powers are ambiguous, written beneficiary consent obtained before the sale is cheaper than a dispute after it.

Replacement choices for a trustee who must weigh a disabled beneficiary's income against tax efficiency

Prudent-investor statutes such as California Probate Code §16047 require a trustee to weigh expected tax consequences, liquidity needs and total return, and §16003 requires impartiality between a current beneficiary who needs income and remainder beneficiaries who inherit later. A taxable sale that surrenders a fifth of the equity serves neither group, while a trust that stays a landlord may fail a beneficiary who needs reliable monthly cash.

A 1031 into one or more Delaware Statutory Trusts keeps the deferral and swaps management for monthly distributions, because Rev. Rul. 2004-86 treats every DST interest as a fractional, undivided piece of the underlying real estate. Net-lease property or a direct title security fits a trust that wants a single tenant and fee title instead.

For a medically fragile or disabled beneficiary, the trustee should coordinate the distribution pattern with whoever manages public benefits, because the trust's payouts, not the exchange, drive eligibility. Document the exchange decision and the distribution policy separately.

• The trust's adjusted basis, depreciation taken and the projected tax on a taxable sale.
• The monthly income the current beneficiary needs and what each replacement option is projected to distribute.
• Why the chosen replacement satisfies the prudent-investor and impartiality duties, in a dated trustee memo.

Related-party and cash traps a trustee can walk into: buying from a beneficiary, or taking money out

Under §267(b)(4) through (b)(6), a trust is related to its grantor, its trustee and its beneficiaries, and §1031(f) applies the two-year holding rule to exchanges between related persons. Rev. Rul. 2002-83 goes further: if the trust sells through a qualified intermediary and buys its replacement from a related party who walks away with the cash, §1031(f)(4) denies the deferral entirely.

So the trust can sell to an outsider and buy from an outsider freely, but a plan to sell the rental and buy a beneficiary's property, or the grantor's, is where trusts get caught. A sale of the relinquished property to a beneficiary is not itself prohibited, but the buyer's resale inside two years and the anti-abuse rule in §1031(f)(4) both need counsel's review.

Cash pulled out at closing is taxable boot, and Reg. §1.1031(k)-1(g)(6) bars the trust from touching the proceeds during the exchange period. Adding trust cash to buy a larger replacement is allowed and creates no boot; distributing exchange proceeds to beneficiaries does the opposite.