A Guide to Estate Planning for Real Estate Investors

Real estate is one of the most estate-tax-inefficient asset classes to own at death — and one of the most estate-tax-efficient to plan around during lifetime. The difference between those two outcomes depends almost entirely on whether the investor has done the planning.

The Basis Step-Up: The Most Valuable Tool Most Investors Ignore

When a real estate investor dies holding appreciated property, the property receives a stepped-up basis to fair market value. That eliminates decades of built-in capital gain — including depreciation recapture — at no income tax cost. For properties that have been held for many years and heavily depreciated, the basis step-up can be worth more than any estate planning technique available.

The implication is counterintuitive: for real estate investors with heavily depreciated, modestly appreciated properties, holding those assets until death may produce better after-tax results than transferring them during lifetime — even if the transfer avoids estate tax.

The Other Side: High-Appreciation Properties and Estate Tax

For properties with significant unrealized appreciation — land, high-growth markets, commercial properties with strong income — the calculus shifts. Here, the estate tax cost of holding the asset until death may exceed the income tax savings from the basis step-up. These are the properties that benefit most from lifetime transfer strategies.

Entity Structure and Valuation Discounts

Real estate held through LLCs or limited partnerships may qualify for valuation discounts when transferred for gift or estate tax purposes. A 30 percent discount on a $10 million LLC interest reduces the transfer tax value to $7 million — saving roughly $1.2 million in gift or estate tax at a 40 percent rate.

To support these discounts, the entity must have genuine business purpose, operating formalities must be maintained, and the discounts must be supported by a qualified appraisal.

1031 Exchanges and Estate Planning

Section 1031 exchanges allow investors to defer capital gains on real estate sales by reinvesting in like-kind property. From an estate planning perspective, 1031 exchanges can be a powerful deferral tool — but they defer, rather than eliminate, the gain. At death, the stepped-up basis eliminates the deferred gain entirely.

For investors with significant 1031 exchange portfolios, the interaction between the exchange mechanics, the estate tax, and the basis step-up requires careful coordination.

DSTs and Estate Planning Considerations

Delaware statutory trusts (DSTs) are increasingly popular as 1031 exchange vehicles. From an estate planning perspective, DST interests are passive, undivided interests in real property — which may support valuation discounts but also raise questions about how the interest is titled, how it is held in the estate, and how it transfers at death. These questions need to be addressed in the estate plan.