Trust Distributes the Property to the Heirs, Who Then Exchange

The decision is who sells: the trust as one taxpayer, or each heir with a deeded share

A trust that holds a building at termination has three exits. The trustee can sell and distribute cash, the trustee can exchange as one taxpayer before the trust winds up, or the trustee can deed each heir an undivided share so each heir decides alone. Only the third lets one sibling exchange into replacement property while another takes cash at the same closing.

The trust-level exchange is the subject of trust-owned 1031 strategies, and a straight sale keeps the gain inside the trust, where it is taxed at compressed rates. Section 643(a)(3) excludes capital gains allocated to corpus from distributable net income, so gain from a trustee's sale usually stays on the trust's own return. For 2026, Rev. Proc. 2025-32 puts trust income above $16,000 in the 37% bracket and starts the 20% capital gain rate at $16,250.

Distribution in kind avoids that. Under section 643(e) the heir's basis is the trust's adjusted basis, and the trust recognizes no gain unless the trustee makes the section 643(e)(3) election to treat the distribution as a sale at fair market value. Each heir then owns real property, which is what section 1031(a)(1) requires.

Basis decides whether an exchange is worth the effort, and the trust type decides basis

A revocable living trust is the easy case. Section 1014(b)(2) treats property the decedent transferred into a revocable trust as property acquired from the decedent, so basis resets to date-of-death value. If the share is sold within a year or two of death, the gain may be small enough that a cash sale beats the cost and deadlines of an exchange.

An irrevocable trust that kept the property out of the grantor's taxable estate is the hard case. Rev. Rul. 2023-2 holds that assets outside the gross estate get no section 1014 adjustment at the grantor's death, even when the grantor was taxed on the trust's income. The heirs inherit the grantor's original basis less depreciation, and the deferred gain becomes theirs; no-step-up trusts covers that basis problem in depth.

Holding period follows basis. A carryover share tacks the trust's holding period under section 1223(2), and stepped-up inherited property sold within a year of death is still treated as held more than one year under section 1223(9). Either way, the gain on an heir's share is long-term.

PLR 202416012 shows how to keep the distribution from looking prearranged

The risk in this sequence is the held-for-investment test. The IRS has ruled that a taxpayer who receives property in a prearranged plan to exchange it, or who acquires replacement property to hand it to someone else, does not hold it for investment, citing Rev. Rul. 75-292 and Rev. Rul. 77-337.

In PLR 202416012 a testamentary trust ended when the last measuring life died, after the trustees had already negotiated a sale. The trustees distributed undivided shares, subject to the sales contract, to single-member LLCs owned by the beneficiaries who wanted to exchange, and each ran a separate exchange. The IRS ruled the distribution did not preclude the shares from being held for investment, because the termination was fixed by the decedent, the distribution would happen whether or not anyone exchanged, and the winding-up period had not been unduly postponed.

A private letter ruling binds the IRS only for the taxpayer who requested it, and section 6110(k)(3) bars citing it as precedent. It is still the clearest map available, and its facts are the ones to copy: a distribution required by the trust's own terms, made independently of any heir's exchange, and completed within a reasonable winding-up period.

Hypothetical: three heirs, one $2,400,000 building, three different outcomes

Hypothetical: an irrevocable trust outside the grantor's estate holds a debt-free apartment building worth $2,400,000 with an adjusted basis of $600,000. The trust terminates and deeds a one-third share to each of three heirs, so each share is worth $800,000 with a $200,000 carryover basis and $600,000 of built-in gain.

Run your own numbers with your CPA; the split of the gain between depreciation and appreciation, the heirs' other income and state tax all move the result.

• Heir A signs an exchange agreement with a qualified intermediary before closing and acquires $800,000 of replacement property, for example a basket of DST interests. A recognizes nothing and carries the $200,000 basis into the replacements.
• Heir B takes $800,000 in cash and reports the $600,000 gain: the depreciation portion at up to 25%, the rest at up to 20%, and the 3.8% net investment income tax above $250,000 of joint income.
• Heir C reinvests $500,000 and takes $300,000 in cash. Under section 1031(b) C recognizes gain up to the $300,000 of boot and defers the remaining $300,000.
• Had the building sat in a revocable trust that stepped up to $2,400,000 at death a year earlier, each heir's gain would be close to zero, and B's choice would cost almost nothing.

Sizing each heir's replacement, including DST interests, starts the day the deeds record

Each heir is a separate exchanger with a separate 45-day list and 180-day deadline, both measured from the closing on that heir's share. Each heir must reinvest that share of net proceeds and replace that share of any mortgage paid off, as laid out in the exchange equation.

DST interests suit this because each heir can buy a different amount in different offerings. Rev. Rul. 2004-86 treats a DST interest as an interest in the underlying real estate for section 1031, and sponsors set their own minimum purchase, so check DST minimums and sizing against each heir's share before the list is due. Under Reg. section 1.1031(k)-1(c)(4), an heir may identify up to three properties of any value, or more if their total value does not exceed 200% of that heir's relinquished share.

Keep the co-ownership from becoming a partnership between distribution and closing. Rev. Proc. 2002-22, the IRS's ruling guideline for co-owned rental property, conditions a ruling that co-owners are not a business entity on no partnership return, no business conducted under a common name, no holding out as partners, and no more than 35 co-owners. Siblings who already hold their shares should read splitting inherited title for the mechanics.