The short answer
A non-grantor generation-skipping trust is its own taxpayer, so the trustee can complete a 1031 exchange in the trust's name exactly as an individual would. For a fully exempt trust it is often the only deferral available: the property is not in any beneficiary's estate, and section 2654(a)(2) scales any basis adjustment at a death-triggered taxable termination by the inclusion ratio, which is zero. A taxable sale is hit at the trust's compressed rates, which reach 37% above $16,000 of income in 2026. The trustee's prudent-investor duty requires weighing that tax cost, diversification and the beneficiaries' need for income before deciding.
At a glance
| 2026 GST exemption | $15,000,000 per transferor under section 2631(c), per Rev. Proc. 2025-32 |
|---|---|
| GST tax rate | The maximum estate tax rate, 40%, multiplied by the trust's inclusion ratio |
| Basis at a beneficiary's death | Adjusted only in proportion to the inclusion ratio under section 2654(a)(2); none for a fully exempt trust |
| Trust's top income bracket | 37% above $16,000 of 2026 taxable income |
| Trust's 20% gain rate | Starts at $16,250 of 2026 taxable income |
| Trust NIIT | 3.8% on the lesser of undistributed net investment income or income above $16,000 |
| Depreciation in a trust | Split between trustee and income beneficiaries by the trust instrument, or by income, under section 167(d) |
A GST-exempt trust will not get a step-up later, so a taxable sale is permanent tax
Families fund dynasty trusts precisely so the assets skip estate tax at each generation. The income tax price is that the assets also skip the basis reset that section 1014 gives property included in a decedent's estate. When a child's interest ends at death and the trust continues for grandchildren, section 2654(a)(2) allows a 1014-style adjustment only in proportion to the inclusion ratio, and a trust fully covered by exemption has an inclusion ratio of zero under section 2642(a).
So the trust's basis in a building is the grantor's basis, reduced by every year of depreciation the trust has taken. A sale recognizes all of that built-in gain, and no later event erases it. Grantor trusts that are outside the grantor's estate are in the same position at the grantor's death under Rev. Rul. 2023-2, which no-step-up trusts covers.
That leaves three choices for a trustee holding a building that no longer fits: hold it, sell it and pay, or exchange it. Holding keeps the deferral but not the problem the trustee wanted to solve, whether that is management, concentration or a weak tenant. Only an exchange changes the asset without paying the gain.
The trustee runs the exchange: the trust signs, takes title and files Form 8824
A non-grantor trust is the taxpayer for its own sales. The trustee signs the exchange agreement with the qualified intermediary, identifies replacement property within 45 days and closes within 180 days under section 1031(a)(3), takes title in the trust's name, and reports the exchange on Form 8824 with the trust's Form 1041. The trust-owned exchange guide covers grantor-versus-non-grantor mechanics.
Read the trust's investment powers before listing. Many dynasty trusts were drafted to hold a family building and may restrict sales, leverage or pooled investments, and a DST interest is a beneficial interest in a trust, which some instruments address separately from direct real estate.
Within the trust, the exchange is a change of investments, not a new transfer into the trust. Ask GST counsel to confirm that the trust's exempt status is undisturbed, particularly if any family member or related entity is on the other side of the deal.
Hypothetical: a $3,000,000 building, a $1,000,000 basis and about $505,000 of federal tax on a sale
Hypothetical: a fully exempt dynasty trust owns a commercial building worth $3,000,000 with an adjusted basis of $1,000,000. Of the $2,000,000 gain, $600,000 is unrecaptured section 1250 gain from depreciation, and the trustee would allocate the whole gain to corpus.
Because section 643(a)(3) keeps corpus gains out of distributable net income, the trust pays the tax itself. Using the 2026 trust brackets in Rev. Proc. 2025-32, the depreciation layer costs about $149,000 at rates capped at 25%, the remaining $1,400,000 costs $280,000 at 20%, and the 3.8% tax of section 1411(a)(2) on income above $16,000 adds about $75,000. That is roughly $505,000 federal before state tax.
An exchange into $3,000,000 of replacement real estate defers all of it, and the replacement takes the $1,000,000 basis forward. Run your own numbers with your CPA, because trust deductions, state tax and the precise split of the gain move the result.
DST income flows through the trust, and the instrument decides who gets depreciation
A DST suits a trustee who must keep the asset but cannot manage it. Rev. Rul. 2004-86 treats each investor as owning an undivided fractional interest in the trust's real estate, so the dynasty trust reports its share of rent, interest and depreciation directly on its Form 1041.
Rent the trust distributes to beneficiaries carries out distributable net income under sections 661 and 662, so the beneficiaries pay tax at their own rates on what they receive. Section 167(d) apportions depreciation between income beneficiaries and the trustee as the instrument provides, or by income allocable to each if it is silent.
Distributions from a fully exempt trust to grandchildren carry no GST tax. If the trust is only partly exempt, each distribution to a skip person is a taxable distribution under section 2612(b), taxed at 40% times the inclusion ratio. Distributions are not guaranteed, and when the DST sells its property, the gain lands on the trust unless the trustee exchanges again, as described in what happens when a DST sells.
Prudent-investor duties make tax cost, diversification and liquidity part of the decision
State trust law sets the trustee's investment standard, and California's version of the Uniform Prudent Investor Act shows what it asks: Probate Code section 16047 tells a trustee to consider the expected tax consequences of investment decisions and the beneficiaries' needs for liquidity and regular income, and section 16048 imposes a duty to diversify unless it is prudent not to.
A single building can fail the diversification test, and a taxable sale to fix it costs a large part of the corpus. Exchanging into several replacements, or into several DST interests across property types and regions, addresses both duties at once, at the cost of the illiquidity described in DST exits.
Document the analysis: the tax cost of selling, the alternatives considered, the beneficiaries' income needs and why the chosen replacements fit. That record is what protects a trustee if a beneficiary later questions the decision. Revisit it at each replacement's sale, because the same analysis applies every time the trust exchanges again.
Related questions
Does a 1031 exchange use up any of the trust's GST exemption?
An exchange is a change of investments inside the trust, not a new transfer to it, so no exemption is allocated. Confirm with GST counsel, particularly when a related party is involved.
Can a beneficiary exchange the trust's building in their own name?
No. The trust owns the property and is the taxpayer, so only the trustee can exchange it. A beneficiary can exchange only property the trust has actually distributed to them.
Will the grandchildren get a step-up when the trust finally ends?
Not from the trust's termination if the trust is fully exempt, because section 2654(a)(2) scales any adjustment by an inclusion ratio of zero. A beneficiary who later dies owning distributed property gets a section 1014 reset at that point.
Who reports the income from DST interests the trust owns?
The trust does, on Form 1041, using the sponsor's grantor-trust statement. Distributed income then passes to beneficiaries on Schedule K-1.
Is a cash-flowing DST always the right replacement for a dynasty trust?
Not always. A trust with income beneficiaries may need current distributions, while a trust that accumulates may value a different risk profile; the instrument and the beneficiaries' needs decide.
Sources
Checked against these publications on September 30, 2026. Rules and figures change; confirm the current version with your CPA or attorney before you act. This page is general information, not tax or legal advice.
- 26 U.S.C. Section 2654 (GST special rules, basis adjustment)
- 26 U.S.C. Section 2642 (inclusion ratio)
- 26 U.S.C. Section 2641 (applicable rate)
- 26 U.S.C. Section 2612 (taxable termination and distribution)
- 26 U.S.C. Section 2001 (estate tax rate schedule)
- IRS, Rev. Proc. 2025-32 (2026 inflation adjustments)
- 26 U.S.C. Section 1411 (net investment income tax)
- 26 U.S.C. Section 643 (distributable net income)
- 26 U.S.C. Section 661 (deduction for distributions)
- 26 U.S.C. Section 662 (inclusion by beneficiaries)
- 26 U.S.C. Section 167 (depreciation, trusts and estates)
- 26 U.S.C. Section 1031
- IRS, Rev. Rul. 2004-86
- California Probate Code Section 16047 (prudent investor rule)
- California Probate Code Section 16048 (duty to diversify)