Inherited property tax explained: Know how the US 1031 exchange works and what are the rules for co-inheritors?

Inheriting a rental property or land and later selling it can lead to a tax bill on any taxable gain, but Section 1031 of the US tax code can delay it, but only in some cases. Notably, rules for heirs aren't that simple. In simple terms, in the United States, a provision known as a 1031 exchange may offer a way for an heir to exchange qualifying investment real estate for another property and defer the tax on the gain. But, the rules may get complicated when several people inherit the same property.

What is a 1031 exchange?

Under it, an owner can usually defer tax on a gain when qualifying real estate held for investment is exchanged for other qualifying real estate.

For example, a rental house can be swapped for land or an apartment building. The tax is not erased, but delayed. In a typical deferred 1031 exchange, the taxpayer usually has 45 days to find potential replacement properties in writing and 180 days to complete the exchange and acquire the replacement property.

Can inherited property qualify?

Yes, it may, but it is held for business use or investment. According to the law, there is no minimum holding time. Notably, a person that inherits a property and later sells it quickly can face questions. They can be inquired about whether they wanted the property as investment or not.

Meanwhile, the tax cost of inherited property is usually set to its fair market value on the date of the owner's death. Notably some heirs use an exchange to defer tax on later growth, while some sell with less tax.

One strategy that is also discussed is called "drop and swap." It means property that is jointly owned can be distributed into separate ownership interests. The individual owners can then decide what to do with their respective interests. This needs careful planning as dividing property just before sale does not make the transaction eligible for a 1031 exchange.

What is the takeaway?

The main takeaway for families in the US is that co-inheritors may in some cases have different options. One heir may sell, while another may potentially pursue a 1031 exchange.