Two separate tax questions come up whenever real estate passes from one generation to the next: whether the estate itself owes federal estate tax on the property's value, and what happens to any built-in capital gain the property was carrying at the time of death. They're calculated differently, apply to different people, and the answer to one has almost nothing to do with the answer to the other, which is where a lot of confusion starts for a Tampa property owner thinking about how to structure a hold for the next generation.
The Federal Exemption Covers Most Estates, but Not All
The federal estate tax only applies once a person's total estate - real estate, investments, business interests, everything - exceeds a large exemption amount that's indexed for inflation and has moved substantially over the past two decades depending on the tax law in effect. Most individual estates fall under the threshold and owe no federal estate tax at all, though an owner with a large commercial real estate portfolio, especially combined with other assets, can exceed the exemption more easily than they'd expect, and the exemption amount is also scheduled to change under current law, which makes this a number worth checking with an estate attorney rather than assuming from memory.
Step-Up in Basis Erases the Deferred Gain at Death
This is the part that changes 1031 planning the most: when an owner dies still holding real estate, the property's basis generally resets to its fair market value as of the date of death, which means any capital gain that had built up during the owner's lifetime - including gain that had been deferred through prior exchanges - is essentially erased for the heirs. An heir who sells the inherited property shortly after receiving it typically owes little or no capital gains tax, because their basis is the stepped-up value rather than whatever the original owner's low basis was after years of deferred exchanges.
Estate Tax and Capital Gains Tax Are Calculated on Different Numbers
Estate tax, when it applies, is calculated on the full fair market value of the property at death, regardless of what the original basis was or how much gain had been deferred over the years. Capital gains tax, by contrast, only ever applies to the difference between sale price and basis, and after a step-up that gap has effectively reset to zero. A property can generate no capital gains liability for the heirs while still counting fully toward the taxable estate if the overall estate exceeds the exemption, so an owner focused only on avoiding capital gains tax through repeated exchanges can end up with a larger taxable estate than they realized.
Gifting During Life Doesn't Get the Same Step-Up
Real estate given away as a gift during the owner's lifetime carries over the giver's original basis to the recipient, without the step-up that happens at death, which means a child who receives a Tampa rental property as a lifetime gift and later sells it inherits the same low basis - and the same capital gains exposure - the parent had been carrying. This is one of the more common estate planning mistakes: gifting appreciated real estate early to avoid probate can actually cost the family more in capital gains tax than simply holding the property until death and letting the step-up apply.
Continuing to Exchange Late in Life Still Has a Purpose
Because the step-up wipes out deferred gain at death regardless of how many prior exchanges took place, an aging owner sometimes asks whether there's still a reason to keep exchanging rather than simply selling and paying the tax. The answer is usually yes if the goal is to keep capital fully invested and growing until death - every exchange still avoids a taxable event during the owner's lifetime, and the eventual step-up means that deferred gain, however large it's grown, is never actually collected by the IRS as long as the property passes to heirs rather than being sold first. Selling outright during life converts the same gain into an immediate tax bill that the step-up would have avoided.
Common 1031 Exchange Questions
Does a 1031 exchange avoid estate tax?
No, an exchange defers capital gains and depreciation recapture, but the full fair market value of the replacement property is still counted in the taxable estate if the owner dies holding it and the overall estate exceeds the exemption.
What happens if you've done several exchanges and then pass the property to your kids?
The step-up in basis at death generally applies to the current replacement property regardless of how many prior exchanges built up the deferred gain, so the heirs typically inherit at the current fair market value with the deferred gain effectively erased.
Is Florida estate tax different from federal estate tax?
Florida doesn't impose its own state estate or inheritance tax, so only the federal exemption and rate apply to property held here, unlike some states that layer their own estate tax on top of the federal one.
Should you gift your rental property to your children now or wait?
It depends on the overall estate plan, but gifting during life generally carries over your original low basis while waiting until death usually allows a step-up, so this is worth reviewing with an estate attorney before deciding either way.
Does a DST held at death also get a step-up in basis?
Generally yes, a beneficial interest in a Delaware Statutory Trust used as 1031 replacement property is treated similarly to direct real estate ownership for basis step-up purposes, though the specific trust structure should be confirmed with an estate attorney.
