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Seller financing comes up most frequently where the seller is the taxpayer under an exchange, and the taxpayer is providing some seller financing to the buyer. However, it can also come up where the taxpayer is receiving seller financing from the seller of the replacement property.
What is seller financing?
Seller financing occurs when a person selling real estate is willing to let the purchaser pay the purchase price over time. This can be done for a wide variety of reasons such as the buyer cannot qualify for a conventional loan, or the economics of the deal require a lower interest rate compared to an outside lender. In this case the seller “holds the paper” requiring the taxpayer to pay the seller over time on specified terms. In general, it will also allow the seller to report the income from the periodic payments in the year in which they are received rather than all in the year of an outright sale.
How does seller financing work?
Seller financing can be structured in a couple of ways. One allows the buyer to receive title to the property at the time of closing and the other allows the buyer to take title upon payment of the last installment. More specifically, the first way would be documented with a promissory note from the buyer to the seller. This note would specify the interest rate, the length of time over which the loan was amortized, and the monthly payment amount. The note would typically be secured by a mortgage in favor of the seller as a lien against the property. In some jurisdictions the security interest used may be referred to as a trust deed or deed of trust.
The second way of documenting the transaction would entail some kind of installment contract between the parties. Again, there are regional differences regarding the name of that contract. It can be called an Installment Agreement for Deed or a Contract for Deed or Articles of Agreement for Deed. For tax and exchange purposes they are all the same. Generally, there would be some money paid down from the buyer to the seller and the balance financed over time. Sometimes it will be paid off at the time of the last fixed payment and in other instances it has a balloon payment for the final lump sum.
Whether the transaction is documented by a deed transfer at the time of the initial closing and secured by a note and mortgage or the deed passing upon final payment the tax treatment is the same. The buyer still owns the property either way, but subject to all payments being made. An analogy can be made to buying a new car with some dealer financing. In the case of an installment contract, the buyer owns the car but will not get clear title until it is paid off.
Regardless of the structure, the documents should show the funds payable to the Qualified Intermediary. Funds paid to the taxpayer would constitute “boot” and therefore taxable.
How does seller financing work with an exchange if the taxpayer is financing the buyer?
This can be a bit tricky. For §1031 purposes, a taxpayer only has 180 days from the date of sale of the relinquished property to acquire the replacement property. For there to be total tax deferral, the full value of the sale property must be reinvested into the replacement property. But when seller financing is involved, the seller does not have the full value to roll over. There are times when the full value will be paid into the exchange account within the 180 day window but more often than not, it will be paid after the 180 day exchange period. So, payments coming into the exchange account can be used towards the acquisition of replacement property, but funds payable after that 180 day term cannot.
Although there are various ways to deal with this, the most common one is for the seller to “advance” the balance due for the replacement property with personal funds. Those funds can come from the taxpayer directly or can be borrowed by the taxpayer. The exchange balance plus the additional funds are used to acquire the replacement property. The note and mortgage or the installment sale agreement is then assigned from the Qualified Intermediary to the taxpayer. Since the necessary value was invested on a timely basis into the replacement property, the receipt by the taxpayer of principal payments over time under the financing document are not taxable.
How does seller financing work with an exchange if the taxpayer is receiving financing from the Seller?
This situation is not as complicated as when the taxpayer is financing the buyer. In any exchange, in order to have complete deferral, a taxpayer has to reinvest all the net proceeds from the sale and have equal or greater new debt compared to debt paid off at the relinquished property closing. Debt in the form of the balance due under the seller financing structure counts just like conventional financing, so it would typically offset the debt requirement to have equal or greater debt on the replacement property.
In summary, seller financing is a part of many real estate transactions. However, due to the rules around §1031 exchanges, some special steps need to be taken on account of the seller financing. If the taxpayer is selling, the loan must be documented so that the exchange company is the payee of the loan, and the applicable security interest should correspond. Once the loan document is monetized from a cash infusion by the taxpayer, the necessary amount can be exchanged into the replacement property. Ultimately, the security interest is assigned to the taxpayer and the taxpayer will not recognize any tax on the principal received over time due to the advancement of the funds at the time of the exchange. In the event the taxpayer is receiving the seller financing in connection with the purchase of the replacement property, such debt obligation is treated no differently than any other loan from a conventional financing source. The seller financing debt will offset debt paid off upon closing of the relinquished property.

Seller financing comes up most frequently where the seller is the taxpayer under an exchange, and the taxpayer is providing some seller financing to the buyer. However, it can also come up where the taxpayer is receiving seller financing from the seller of the replacement property.
What is seller financing?
Seller financing occurs when a person selling real estate is willing to let the purchaser pay the purchase price over time. This can be done for a wide variety of reasons such as the buyer cannot qualify for a conventional loan, or the economics of the deal require a lower interest rate compared to an outside lender. In this case the seller “holds the paper” requiring the taxpayer to pay the seller over time on specified terms. In general, it will also allow the seller to report the income from the periodic payments in the year in which they are received rather than all in the year of an outright sale.
How does seller financing work?
Seller financing can be structured in a couple of ways. One allows the buyer to receive title to the property at the time of closing and the other allows the buyer to take title upon payment of the last installment. More specifically, the first way would be documented with a promissory note from the buyer to the seller. This note would specify the interest rate, the length of time over which the loan was amortized, and the monthly payment amount. The note would typically be secured by a mortgage in favor of the seller as a lien against the property. In some jurisdictions the security interest used may be referred to as a trust deed or deed of trust.
The second way of documenting the transaction would entail some kind of installment contract between the parties. Again, there are regional differences regarding the name of that contract. It can be called an Installment Agreement for Deed or a Contract for Deed or Articles of Agreement for Deed. For tax and exchange purposes they are all the same. Generally, there would be some money paid down from the buyer to the seller and the balance financed over time. Sometimes it will be paid off at the time of the last fixed payment and in other instances it has a balloon payment for the final lump sum.
Whether the transaction is documented by a deed transfer at the time of the initial closing and secured by a note and mortgage or the deed passing upon final payment the tax treatment is the same. The buyer still owns the property either way, but subject to all payments being made. An analogy can be made to buying a new car with some dealer financing. In the case of an installment contract, the buyer owns the car but will not get clear title until it is paid off.
Regardless of the structure, the documents should show the funds payable to the Qualified Intermediary. Funds paid to the taxpayer would constitute “boot” and therefore taxable.
How does seller financing work with an exchange if the taxpayer is financing the buyer?
This can be a bit tricky. For §1031 purposes, a taxpayer only has 180 days from the date of sale of the relinquished property to acquire the replacement property. For there to be total tax deferral, the full value of the sale property must be reinvested into the replacement property. But when seller financing is involved, the seller does not have the full value to roll over. There are times when the full value will be paid into the exchange account within the 180 day window but more often than not, it will be paid after the 180 day exchange period. So, payments coming into the exchange account can be used towards the acquisition of replacement property, but funds payable after that 180 day term cannot.
Although there are various ways to deal with this, the most common one is for the seller to “advance” the balance due for the replacement property with personal funds. Those funds can come from the taxpayer directly or can be borrowed by the taxpayer. The exchange balance plus the additional funds are used to acquire the replacement property. The note and mortgage or the installment sale agreement is then assigned from the Qualified Intermediary to the taxpayer. Since the necessary value was invested on a timely basis into the replacement property, the receipt by the taxpayer of principal payments over time under the financing document are not taxable.
How does seller financing work with an exchange if the taxpayer is receiving financing from the Seller?
This situation is not as complicated as when the taxpayer is financing the buyer. In any exchange, in order to have complete deferral, a taxpayer has to reinvest all the net proceeds from the sale and have equal or greater new debt compared to debt paid off at the relinquished property closing. Debt in the form of the balance due under the seller financing structure counts just like conventional financing, so it would typically offset the debt requirement to have equal or greater debt on the replacement property.
In summary, seller financing is a part of many real estate transactions. However, due to the rules around §1031 exchanges, some special steps need to be taken on account of the seller financing. If the taxpayer is selling, the loan must be documented so that the exchange company is the payee of the loan, and the applicable security interest should correspond. Once the loan document is monetized from a cash infusion by the taxpayer, the necessary amount can be exchanged into the replacement property. Ultimately, the security interest is assigned to the taxpayer and the taxpayer will not recognize any tax on the principal received over time due to the advancement of the funds at the time of the exchange. In the event the taxpayer is receiving the seller financing in connection with the purchase of the replacement property, such debt obligation is treated no differently than any other loan from a conventional financing source. The seller financing debt will offset debt paid off upon closing of the relinquished property.

Seller financing comes up most frequently where the seller is the taxpayer under an exchange, and the taxpayer is providing some seller financing to the buyer. However, it can also come up where the taxpayer is receiving seller financing from the seller of the replacement property.
What is seller financing?
Seller financing occurs when a person selling real estate is willing to let the purchaser pay the purchase price over time. This can be done for a wide variety of reasons such as the buyer cannot qualify for a conventional loan, or the economics of the deal require a lower interest rate compared to an outside lender. In this case the seller “holds the paper” requiring the taxpayer to pay the seller over time on specified terms. In general, it will also allow the seller to report the income from the periodic payments in the year in which they are received rather than all in the year of an outright sale.
How does seller financing work?
Seller financing can be structured in a couple of ways. One allows the buyer to receive title to the property at the time of closing and the other allows the buyer to take title upon payment of the last installment. More specifically, the first way would be documented with a promissory note from the buyer to the seller. This note would specify the interest rate, the length of time over which the loan was amortized, and the monthly payment amount. The note would typically be secured by a mortgage in favor of the seller as a lien against the property. In some jurisdictions the security interest used may be referred to as a trust deed or deed of trust.
The second way of documenting the transaction would entail some kind of installment contract between the parties. Again, there are regional differences regarding the name of that contract. It can be called an Installment Agreement for Deed or a Contract for Deed or Articles of Agreement for Deed. For tax and exchange purposes they are all the same. Generally, there would be some money paid down from the buyer to the seller and the balance financed over time. Sometimes it will be paid off at the time of the last fixed payment and in other instances it has a balloon payment for the final lump sum.
Whether the transaction is documented by a deed transfer at the time of the initial closing and secured by a note and mortgage or the deed passing upon final payment the tax treatment is the same. The buyer still owns the property either way, but subject to all payments being made. An analogy can be made to buying a new car with some dealer financing. In the case of an installment contract, the buyer owns the car but will not get clear title until it is paid off.
Regardless of the structure, the documents should show the funds payable to the Qualified Intermediary. Funds paid to the taxpayer would constitute “boot” and therefore taxable.
How does seller financing work with an exchange if the taxpayer is financing the buyer?
This can be a bit tricky. For §1031 purposes, a taxpayer only has 180 days from the date of sale of the relinquished property to acquire the replacement property. For there to be total tax deferral, the full value of the sale property must be reinvested into the replacement property. But when seller financing is involved, the seller does not have the full value to roll over. There are times when the full value will be paid into the exchange account within the 180 day window but more often than not, it will be paid after the 180 day exchange period. So, payments coming into the exchange account can be used towards the acquisition of replacement property, but funds payable after that 180 day term cannot.
Although there are various ways to deal with this, the most common one is for the seller to “advance” the balance due for the replacement property with personal funds. Those funds can come from the taxpayer directly or can be borrowed by the taxpayer. The exchange balance plus the additional funds are used to acquire the replacement property. The note and mortgage or the installment sale agreement is then assigned from the Qualified Intermediary to the taxpayer. Since the necessary value was invested on a timely basis into the replacement property, the receipt by the taxpayer of principal payments over time under the financing document are not taxable.
How does seller financing work with an exchange if the taxpayer is receiving financing from the Seller?
This situation is not as complicated as when the taxpayer is financing the buyer. In any exchange, in order to have complete deferral, a taxpayer has to reinvest all the net proceeds from the sale and have equal or greater new debt compared to debt paid off at the relinquished property closing. Debt in the form of the balance due under the seller financing structure counts just like conventional financing, so it would typically offset the debt requirement to have equal or greater debt on the replacement property.
In summary, seller financing is a part of many real estate transactions. However, due to the rules around §1031 exchanges, some special steps need to be taken on account of the seller financing. If the taxpayer is selling, the loan must be documented so that the exchange company is the payee of the loan, and the applicable security interest should correspond. Once the loan document is monetized from a cash infusion by the taxpayer, the necessary amount can be exchanged into the replacement property. Ultimately, the security interest is assigned to the taxpayer and the taxpayer will not recognize any tax on the principal received over time due to the advancement of the funds at the time of the exchange. In the event the taxpayer is receiving the seller financing in connection with the purchase of the replacement property, such debt obligation is treated no differently than any other loan from a conventional financing source. The seller financing debt will offset debt paid off upon closing of the relinquished property.

Generally speaking, capital gains are any profits generated from the sale of assets. Further, people often refer to Section 1031 Exchanges as Tax Deferred Exchanges or Tax-Free Exchanges. The key language of the statute says that “No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.” On its face, the statute is a tool to defer capital gains taxes, not to avoid capital gains taxes.
What is Capital Gains Tax?
Capital gains tax is the tax that American taxpayers (both US citizens and non-citizens) pay on any profits (capital gains) generated from the sale of assets. Those assets include real estate, investments such as stocks, and businesses, among others. According to the IRS, those gains are to be considered taxable income. The IRS has different tax rates for capital gains based on the taxpayer’s income tax bracket, as well has how long the asset was held.
Are There Variations of Capital Gains Tax?
Assets that the taxpayer held for longer than one year result in long-term capital gains, while assets held for less than one year result in short-term capital gains. The Internal Revenue Code treats short-term capital gains the same as any other ordinary income so that the tax rate is the same as your income tax rate. Long-term capital gains at more favorable rates, as shown below.
For 2022, the tax brackets look like this:

How is Capital Gains Tax Calculated?
Generally speaking, if an asset is sold for more than its purchase price (it’s “cost basis”), there is a capital gain. On the other hand, if it is sold for less than it’s purchase price, there is a capital loss. But the Internal Revenue Code makes things a little more complicated, and calculates gain or loss based on the asset’s “adjusted basis.” To arrive at the adjusted basis, the taxpayer will start with the cost basis, and then add the cost of capital improvements, and subtract any depreciation taken. Note that only improvements to real estate can be depreciated, and the value of the land itself never depreciates. Use our Depreciation Calculator. 
To determine the final capital gains tax burden, the taxpayer would start by calculating the adjusted basis as described above, and subtract that from the current sale price; the difference is the capital gain. If the asset was held for longer than one year, the gain would be taxed according to the last column in the table above. If the asset was held for less than one year, the gain would be taxed as ordinary income based on the third column. Use our Capital Gains Calculator.
How Does Section 1031 Help with Capital Gains Taxes
As noted above, Section 1031 provides that the gain on the exchange of an asset is not recognized in the year of the sale. Under the Internal Revenue Code, those gains are deferred, and will only be recognized at a time in the future when there is a taxable sale rather than another exchange.
A taxpayer can structure a transaction as a 1031 exchange in 2022, exchange that asset in 2025, exchange again in 2030, exchange again in 2032, and so on. Doing so would continue to defer the gains that accumulate between each sale. If that taxpayer ultimately sells the final asset in 2040, all of the deferred gains from each of those intervening 1031 exchange would be recognized.
But if the taxpayer is going to pay taxes at the end anyway, why exchange in the first place? There are two primary reasons that the taxpayer would structure those exchanges and then ultimately sell in a taxable transaction. First is the time value of money. Simply stated, the time value of money is the concept that a dollar today is worth more than a dollar tomorrow. Ask yourself this – would you rather pay someone $10,000 today, or ten years from now? Most investors would rather pay in ten years rather than today, preferably never if possible. The second reason is that theoretically, a taxpayer will sell their last investment property later in life, perhaps when they have past their peak earning years and are in a lower tax bracket. A married couple reducing their income from $650,000 to $200,000 would see their capital gains rate drop from 20% to 15% – a 25% reduction in the tax rate.
Can Section 1031 be Used to Eliminate or Avoid Capital Gains Tax
Using the scenario above, a taxpayer structures a transaction as a 1031 exchange in 2022, exchanges that asset in 2025, exchanges again in 2030, and exchanges again in 2032, before dying in 2035. Based on the Internal Revenue Code, that taxpayer’s heirs would inherit the final property at the fair market value as of the taxpayer’s death, receiving the property at a “stepped up basis.” The heirs do not need to worry about any accumulated depreciation or capital gains that a taxpayer had meticulously avoided through deferral, and they start with completely fresh basis. If the heirs were to sell the property shortly thereafter, there would be no capital gains to recognize.
By continuing to exchange throughout their life, this taxpayer successfully avoided all depreciation recapture and capital gains taxes. They effectively converted a tax deferred exchange into a tax-free exchange.
Section 1031 can be a powerful investment tool, and an incredibly useful estate planning tool. Taxpayers are encouraged to seek the advice of competent tax and legal counsel before structuring any 1031 exchange.

Generally speaking, capital gains are any profits generated from the sale of assets. Further, people often refer to Section 1031 Exchanges as Tax Deferred Exchanges or Tax-Free Exchanges. The key language of the statute says that “No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.” On its face, the statute is a tool to defer capital gains taxes, not to avoid capital gains taxes.
What is Capital Gains Tax?
Capital gains tax is the tax that American taxpayers (both US citizens and non-citizens) pay on any profits (capital gains) generated from the sale of assets. Those assets include real estate, investments such as stocks, and businesses, among others. According to the IRS, those gains are to be considered taxable income. The IRS has different tax rates for capital gains based on the taxpayer’s income tax bracket, as well has how long the asset was held.
Are There Variations of Capital Gains Tax?
Assets that the taxpayer held for longer than one year result in long-term capital gains, while assets held for less than one year result in short-term capital gains. The Internal Revenue Code treats short-term capital gains the same as any other ordinary income so that the tax rate is the same as your income tax rate. Long-term capital gains at more favorable rates, as shown below.
For 2022, the tax brackets look like this:

How is Capital Gains Tax Calculated?
Generally speaking, if an asset is sold for more than its purchase price (it’s “cost basis”), there is a capital gain. On the other hand, if it is sold for less than it’s purchase price, there is a capital loss. But the Internal Revenue Code makes things a little more complicated, and calculates gain or loss based on the asset’s “adjusted basis.” To arrive at the adjusted basis, the taxpayer will start with the cost basis, and then add the cost of capital improvements, and subtract any depreciation taken. Note that only improvements to real estate can be depreciated, and the value of the land itself never depreciates. Use our Depreciation Calculator. 
To determine the final capital gains tax burden, the taxpayer would start by calculating the adjusted basis as described above, and subtract that from the current sale price; the difference is the capital gain. If the asset was held for longer than one year, the gain would be taxed according to the last column in the table above. If the asset was held for less than one year, the gain would be taxed as ordinary income based on the third column. Use our Capital Gains Calculator.
How Does Section 1031 Help with Capital Gains Taxes
As noted above, Section 1031 provides that the gain on the exchange of an asset is not recognized in the year of the sale. Under the Internal Revenue Code, those gains are deferred, and will only be recognized at a time in the future when there is a taxable sale rather than another exchange.
A taxpayer can structure a transaction as a 1031 exchange in 2022, exchange that asset in 2025, exchange again in 2030, exchange again in 2032, and so on. Doing so would continue to defer the gains that accumulate between each sale. If that taxpayer ultimately sells the final asset in 2040, all of the deferred gains from each of those intervening 1031 exchange would be recognized.
But if the taxpayer is going to pay taxes at the end anyway, why exchange in the first place? There are two primary reasons that the taxpayer would structure those exchanges and then ultimately sell in a taxable transaction. First is the time value of money. Simply stated, the time value of money is the concept that a dollar today is worth more than a dollar tomorrow. Ask yourself this – would you rather pay someone $10,000 today, or ten years from now? Most investors would rather pay in ten years rather than today, preferably never if possible. The second reason is that theoretically, a taxpayer will sell their last investment property later in life, perhaps when they have past their peak earning years and are in a lower tax bracket. A married couple reducing their income from $650,000 to $200,000 would see their capital gains rate drop from 20% to 15% – a 25% reduction in the tax rate.
Can Section 1031 be Used to Eliminate or Avoid Capital Gains Tax
Using the scenario above, a taxpayer structures a transaction as a 1031 exchange in 2022, exchanges that asset in 2025, exchanges again in 2030, and exchanges again in 2032, before dying in 2035. Based on the Internal Revenue Code, that taxpayer’s heirs would inherit the final property at the fair market value as of the taxpayer’s death, receiving the property at a “stepped up basis.” The heirs do not need to worry about any accumulated depreciation or capital gains that a taxpayer had meticulously avoided through deferral, and they start with completely fresh basis. If the heirs were to sell the property shortly thereafter, there would be no capital gains to recognize.
By continuing to exchange throughout their life, this taxpayer successfully avoided all depreciation recapture and capital gains taxes. They effectively converted a tax deferred exchange into a tax-free exchange.
Section 1031 can be a powerful investment tool, and an incredibly useful estate planning tool. Taxpayers are encouraged to seek the advice of competent tax and legal counsel before structuring any 1031 exchange.

Generally speaking, capital gains are any profits generated from the sale of assets. Further, people often refer to Section 1031 Exchanges as Tax Deferred Exchanges or Tax-Free Exchanges. The key language of the statute says that “No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.” On its face, the statute is a tool to defer capital gains taxes, not to avoid capital gains taxes.
What is Capital Gains Tax?
Capital gains tax is the tax that American taxpayers (both US citizens and non-citizens) pay on any profits (capital gains) generated from the sale of assets. Those assets include real estate, investments such as stocks, and businesses, among others. According to the IRS, those gains are to be considered taxable income. The IRS has different tax rates for capital gains based on the taxpayer’s income tax bracket, as well has how long the asset was held.
Are There Variations of Capital Gains Tax?
Assets that the taxpayer held for longer than one year result in long-term capital gains, while assets held for less than one year result in short-term capital gains. The Internal Revenue Code treats short-term capital gains the same as any other ordinary income so that the tax rate is the same as your income tax rate. Long-term capital gains at more favorable rates, as shown below.
For 2022, the tax brackets look like this:

How is Capital Gains Tax Calculated?
Generally speaking, if an asset is sold for more than its purchase price (it’s “cost basis”), there is a capital gain. On the other hand, if it is sold for less than it’s purchase price, there is a capital loss. But the Internal Revenue Code makes things a little more complicated, and calculates gain or loss based on the asset’s “adjusted basis.” To arrive at the adjusted basis, the taxpayer will start with the cost basis, and then add the cost of capital improvements, and subtract any depreciation taken. Note that only improvements to real estate can be depreciated, and the value of the land itself never depreciates. Use our Depreciation Calculator. 
To determine the final capital gains tax burden, the taxpayer would start by calculating the adjusted basis as described above, and subtract that from the current sale price; the difference is the capital gain. If the asset was held for longer than one year, the gain would be taxed according to the last column in the table above. If the asset was held for less than one year, the gain would be taxed as ordinary income based on the third column. Use our Capital Gains Calculator.
How Does Section 1031 Help with Capital Gains Taxes
As noted above, Section 1031 provides that the gain on the exchange of an asset is not recognized in the year of the sale. Under the Internal Revenue Code, those gains are deferred, and will only be recognized at a time in the future when there is a taxable sale rather than another exchange.
A taxpayer can structure a transaction as a 1031 exchange in 2022, exchange that asset in 2025, exchange again in 2030, exchange again in 2032, and so on. Doing so would continue to defer the gains that accumulate between each sale. If that taxpayer ultimately sells the final asset in 2040, all of the deferred gains from each of those intervening 1031 exchange would be recognized.
But if the taxpayer is going to pay taxes at the end anyway, why exchange in the first place? There are two primary reasons that the taxpayer would structure those exchanges and then ultimately sell in a taxable transaction. First is the time value of money. Simply stated, the time value of money is the concept that a dollar today is worth more than a dollar tomorrow. Ask yourself this – would you rather pay someone $10,000 today, or ten years from now? Most investors would rather pay in ten years rather than today, preferably never if possible. The second reason is that theoretically, a taxpayer will sell their last investment property later in life, perhaps when they have past their peak earning years and are in a lower tax bracket. A married couple reducing their income from $650,000 to $200,000 would see their capital gains rate drop from 20% to 15% – a 25% reduction in the tax rate.
Can Section 1031 be Used to Eliminate or Avoid Capital Gains Tax
Using the scenario above, a taxpayer structures a transaction as a 1031 exchange in 2022, exchanges that asset in 2025, exchanges again in 2030, and exchanges again in 2032, before dying in 2035. Based on the Internal Revenue Code, that taxpayer’s heirs would inherit the final property at the fair market value as of the taxpayer’s death, receiving the property at a “stepped up basis.” The heirs do not need to worry about any accumulated depreciation or capital gains that a taxpayer had meticulously avoided through deferral, and they start with completely fresh basis. If the heirs were to sell the property shortly thereafter, there would be no capital gains to recognize.
By continuing to exchange throughout their life, this taxpayer successfully avoided all depreciation recapture and capital gains taxes. They effectively converted a tax deferred exchange into a tax-free exchange.
Section 1031 can be a powerful investment tool, and an incredibly useful estate planning tool. Taxpayers are encouraged to seek the advice of competent tax and legal counsel before structuring any 1031 exchange.