The 2026 Estate Exemption and 1031: Do You Still Need to Defer?

Two different taxes: the exemption shelters your estate from estate tax, the 1031 shelters your gain from income tax

A sale of a rental without an exchange triggers federal income tax in layers: unrecaptured section 1250 gain taxed at up to 25% under section 1(h), the rest of the long-term gain at up to 20%, and the 3.8% net investment income tax under section 1411 once modified adjusted gross income passes $250,000 for joint filers or $200,000 for single filers. State income tax usually comes on top. How much tax you will really pay works through the stack.

The estate tax is separate. Section 2001 taxes the taxable estate on a graduated table that reaches 40%, and the unified credit in section 2010 shelters a basic exclusion amount that the July 2025 act set at $15,000,000, indexed for inflation for deaths after 2026. An exchange does not shrink the estate: the replacement property is included at its fair market value just as the old property would have been.

The step-up is why deferral still pays: it applies to every estate, taxable or not

Section 1014(a) sets the basis of property acquired from a decedent at fair market value on the date of death. Nothing in it depends on whether the estate owed estate tax or filed a Form 706. A $2,000,000 estate and a $40,000,000 estate get the same reset, so gain deferred through a chain of exchanges and held until death is never taxed as income.

The large exemption changes the comparison in favor of deferring. When the exemption was smaller, some families paid estate tax on the full value of property that also carried deferred gain. With $15,000,000 per person, and potentially $30,000,000 for a married couple that elects portability, most owners can defer the income tax, pay no estate tax and pass a clean basis. Portability of the estate exemption covers the filing that makes the second exclusion available.

How a couple holds title changes how much resets at the first death. Under section 1014(b)(6), the surviving spouse's half of community property is also treated as acquired from the decedent, so both halves take the new value. Property held as joint tenants or in a common-law state generally resets only on the decedent's share, with the survivor's half waiting for the second death.

A worked model: the tax a sale costs today against what the heirs owe after a step-up

Hypothetical: a married couple owns a rental worth $3,000,000 with an adjusted basis of $600,000, so the gain is $2,400,000, of which $500,000 is prior depreciation. They have $250,000 of other income. If every layer is taxed at its top federal rate, a sale costs about $125,000 on the depreciation at 25%, $380,000 on the remaining $1,900,000 at 20%, and $91,200 of net investment income tax at 3.8%, roughly $596,000 before state tax. Lower brackets would reduce that figure.

If instead they exchange into replacement property and hold it until the second death, the heirs take a basis equal to its value then. The $2,400,000 of deferred gain and the $500,000 of depreciation are never taxed, and an estate of that size owes no federal estate tax under the 2026 exclusion. The figures are hypothetical; run your own numbers with your CPA.

The model only works if the property is held until death. 1031 vs holding for step-up compares one more exchange with simply holding what you own.

State estate taxes start far lower, but an exchange does not change them either

Several states tax estates well below the federal exclusion. The Washington Department of Revenue sets the filing threshold and exclusion at $3,076,000 for deaths from January 1 to June 30, 2026 and $3,000,000 for deaths on or after July 1, 2026. New York sets its basic exclusion at $7,350,000 for 2026 deaths, and Oregon's Form OR-706 instructions require a return when the gross estate is $1,000,000 or more.

Those taxes are reasons to plan the estate, not reasons to sell. Paying income tax now shrinks the estate only by the tax paid, while deferring and holding still passes the property at a stepped-up basis. If a state estate tax is likely, liquidity for that tax is the real planning issue.

When to stop exchanging: liquidity, gifts and the cost of one more exchange

Stop exchanging when you need the money to live on, because the deferral only becomes permanent if you hold until death. Stop, too, when a further exchange would cost more in commissions and loads than it saves; after a recent inheritance the gain may be small.

Be careful with lifetime gifts. Under section 1015 property acquired by gift generally keeps the donor's basis, so giving a rental to children during life passes the deferred gain to them instead of erasing it. The reverse move does not work either: section 1014(e) denies the step-up when appreciated property is given to someone within one year of their death and comes back to the donor or the donor's spouse. For owners who want to keep deferring without managing property, the swap-till-you-drop approach and DSTs in estate planning cover passive replacements that divide easily among heirs.