Navigating 1031 Exchanges, LP Transfers, and Step-Up in Basis: How to Preserve Both Benefits

When it comes to real estate investing, few strategies are as powerful as combining a §1031 exchange with careful estate planning. The 1031 exchange allows investors to defer capital gains and depreciation recapture taxes when selling appreciated property, while proper estate planning ensures those gains may later be eliminated entirely through a step-up in basis at death.

However, the tax benefits of both depend on one critical factor — maintaining the correct taxpayer identity. Moving properties into new entities like limited partnerships (LPs) or trusts can inadvertently break 1031 continuity or eliminate the step-up at death if not handled correctly.

Here’s how to preserve both.

The “Same Taxpayer” Rule in 1031 Exchanges

A §1031 exchange defers tax only if the same taxpayer who sells the relinquished property also acquires the replacement property.

In practice, this means:

• If an individual sells property through a single-member LLC (a disregarded entity), that individual is the taxpayer.

• The replacement property must also be acquired by the same taxpayer — either in their individual name or through another disregarded entity owned by them.

If the ownership of the replacement property is later transferred to a different taxpayer, such as a partnership or an irrevocable trust with its own EIN, the IRS can view this as breaking the chain of ownership. In that case, any future sale by the new entity would not qualify for continued 1031 deferral.

Transferring to a Partnership After the Exchange

Many investors eventually want to move their replacement properties into a partnership or family limited partnership for management, liability, or estate-planning reasons. The key question becomes: Does such a transfer invalidate the prior 1031 exchange?

The IRS has not set a formal holding period, but case law and rulings emphasize the importance of intent and timing. The taxpayer must have intended to hold the property for investment — not merely as an intermediary for another entity.

To demonstrate this intent, practitioners generally recommend a one-year “seasoning period.”
Holding the replacement property in the same taxpayer’s name for at least 12 months (and ideally over two tax years) shows genuine investment purpose. After that period, transferring ownership to a partnership through a §721 contribution (property exchanged for partnership interest) is generally safe and does not retroactively disqualify the earlier 1031 exchange.

After that transfer:

• The prior 1031 deferral remains intact.

• The partnership becomes the new taxpayer for any future 1031 exchanges.

• Any future sale and exchange must be done under the partnership’s name and EIN.

The Step-Up in Basis at Death

Under §1014, assets included in a decedent’s taxable estate receive a step-up in basis to their fair market value at death. This can completely eliminate both deferred gain and prior depreciation recapture — allowing heirs or a surviving spouse to sell tax-free.

However, this benefit depends on estate inclusion:

• If the property is owned personally or through a grantor trust (Such as the Bridge Trust®), it is included in the estate, and the step-up applies in full.

• If the property has been transferred into a partnership or a non-grantor trust, it may no longer be included in the decedent’s estate. In that case, only a partial step-up (via a §754 election by the partnership) applies to the deceased partner’s share, or possibly none at all.

Thus, once the seasoning period has passed, moving an LLC into the  AMLP structure will both improve asset protection and retain the full basis adjustment on death.

The Balancing Act: Protection vs. Tax Efficiency

Many investors want both protection and tax efficiency — continued 1031 flexibility during life, and full basis step-up at death. The optimal approach is often sequenced planning:

1. Hold the replacement property (through a disregarded LLC) for at least one year after the 1031 exchange closes.

2. Only after that period, contribute the property to a partnership (such as a family LP) via §721, if desired.

3. Ensure that any trust owning the partnership is a grantor trust during your lifetime — keeping you as the taxpayer for both income tax and estate purposes.

4. Upon death, the assets are included in your estate, receiving the full step-up under §1014, after which the structure can become fully irrevocable for long-term protection.

This sequencing satisfies both objectives:

• The 1031 exchange remains valid and unbroken.

• The step-up at death is preserved.

• The asset protection benefits of an LP or trust structure are layered on without triggering premature tax consequences.

Conclusion

The combination of §1031 exchanges and estate planning can yield extraordinary tax savings — potentially deferring gain for life and then eliminating it entirely at death.

But these benefits hinge on one simple truth: the IRS cares deeply who the taxpayer is. Changing the ownership too soon or too drastically can undo years of careful planning.

To keep both the 1031 deferral and the step-up in basis, investors should:

• Maintain the same taxpayer through the exchange and for at least a year thereafter,

• Use disregarded entities or grantor trusts for continuity,

• And only later, when appropriate, transfer the properties into protected partnership or trust structures under §721.

With proper sequencing and structure, you can achieve deferral, protection, and elimination of gain — the holy trinity of tax-efficient real estate investing.

This material is provided for general educational purposes. Always consult your CPA or tax advisor for entity-specific guidance. If you are a Lodmell & Lodmell client, please contact us directly at [e-mail] or 602-230-2014 for specific advice.