The owner signed a sale contract and died before closing: does the estate still need the 1031 exchange?

Title still in the decedent at death usually means a new basis and a sale with almost nothing to defer

Section 1014(b)(1) covers property acquired "by the decedent's estate from the decedent", and subsection (a)(1) sets its basis at "the fair market value of the property at the date of the decedent's death". A rental the decedent still owned on that date, even one under contract, is such property, and Publication 559 confirms that gain or loss on it "is considered long term, regardless of how long you held the property".

Fair market value is defined in Reg. section 20.2031-1(b) as the willing-buyer, willing-seller price, and "all relevant facts and elements of value as of the applicable valuation date shall be considered". A signed arm's-length contract weeks before death is strong evidence of value, so the date-of-death basis usually lands near the contract price, leaving commissions and costs as the main tax item, the result in selling inherited property within six months. With gain near zero, an exchange defers nothing.

The exception: a sale so complete at death that the estate inherited the proceeds, not the property

Section 1014(c) withholds the step-up from "a right to receive an item of income in respect of a decedent", and section 691(a)(1) taxes such items to the estate when received, with the character they would have had in the decedent's hands. Publication 559's examples include a tractor sold on February 1 with payment due March 1 by a farmer who died on February 15: the gain is income in respect of a decedent.

For a sale still open at death, the Eighth Circuit in Estate of Peterson v. Commissioner endorsed a four-part test: whether the decedent entered into a legally significant arrangement, whether the decedent "performed the substantive (nonministerial) acts required as preconditions to the sale", whether "any economically material contingencies which might have disrupted the sale" existed at death, and whether the decedent would have received the proceeds had he lived. The focus is "the status of the transaction itself at the time of the decedent's death".

In Peterson the decedent had signed a calf sale contract and received earnest money, yet the proceeds were not income in respect of a decedent because substantive acts remained. For real estate, an open financing, inspection, title or due diligence contingency generally leaves the property on the stepped-up side; a contract with every condition satisfied and only recording left is the risky case.

The estate decides whether to close, and the exchange agreement does not have to be used

The buyer's contract binds the estate. Minnesota's enactment of the Uniform Probate Code, section 524.3-715(3), lets the personal representative "perform, compromise or refuse performance of the decedent's contracts that continue as obligations of the estate", so the representative can close as scheduled, renegotiate, or decline and face the buyer's remedies.

The exchange agreement is different. Under Reg. section 1.1031(k)-1 the identification and exchange periods begin when the relinquished property is transferred, and the restriction on access to funds in paragraph (g)(6) applies to an exchange that has begun. A decedent who signed an intermediary agreement but had not yet closed had not started an exchange, so the estate can close for cash without a failed-exchange problem; cancelling before the relinquished closing covers the fee question.

Whoever signs the deed must have authority. An informally appointed representative in Minnesota cannot sell the decedent's real estate until 30 days after letters issue under section 524.3-711, so a closing inside that window needs a formal appointment or a special administrator; see who signs the exchange documents after the seller dies.

Hypothetical: a $1,000,000 contract, a $300,000 basis and a death three weeks before closing

Hypothetical, round numbers. The owner signed a contract to sell a rental for $1,000,000 with the buyer's financing and inspection contingencies open, set up an exchange agreement, and died three weeks before closing with an adjusted basis of $300,000.

If the step-up applies, the estate's basis becomes about $1,000,000. After $60,000 of commissions and costs the estate reports roughly a $60,000 loss, which stays in the estate until its final year and then passes to the heirs, as explained in taxes when an estate sells a rental before distribution, and the exchange agreement is simply not used. If instead the contract had closed in substance before death, the $700,000 gain would be income in respect of a decedent taxed to the estate at the decedent's character, including the depreciation slice, and completing the exchange through the estate would defer it. Have counsel apply the Peterson factors in writing before choosing, and run the numbers with the estate's CPA.

• Step-up applies: basis about $1,000,000, small loss after costs, no exchange needed.
• Income in respect of a decedent: $700,000 of gain, no step-up, exchange worth completing.
• The deciding facts: which contingencies were still open on the date of death.

When the estate should still run the exchange

Complete the exchange when the Peterson analysis points to income in respect of a decedent, because deferral then has real value, or when the estate will hold the replacement for years and the heirs want a passive asset rather than cash; an estate can exchange in its own right, as the executor's guide explains. A Delaware statutory trust interest on the list closes by subscription if time is short, but it is illiquid until the trust sells and can lose value; the traditional DST describes the structure.

Where there is no income-in-respect-of-a-decedent risk and the heirs want cash, close for cash and let the step-up do its work. Whether an estate's rental should be exchanged at all once the basis has reset is covered in an executor selling an estate's rental, and the mid-exchange case, where the sale had already closed, in what happens if the owner dies during a 1031 exchange.