The Step-Up in Basis and DST Estate Planning: How Deferred Taxes Become Permanently Eliminated
or real estate investors with significant unrealized gains, one of the most powerful tax strategies in the U.S. tax code isn't a deduction, a credit, or a deferral. It's a combination of three mechanisms, Section 1031 exchanges, Delaware Statutory Trust (DST) ownership, and the step-up in basis at death, that together can eliminate decades of deferred capital gains and depreciation recapture.
This strategy, sometimes called "swap till you drop," is one of the most widely recommended approaches for aging real estate investors transitioning from active ownership to passive income. For RIAs, broker-dealers, and estate planning attorneys, understanding how DSTs fit into this framework has become increasingly important, particularly under the new federal estate tax landscape established by the One Big Beautiful Bill Act of 2025.
How the Step-Up in Basis Works
Under Internal Revenue Code Section 1014, when an asset passes to heirs at death, the heir's cost basis is "stepped up" to its fair market value as of the date of death.
The practical effect is significant. Consider an investor who originally purchased a property for $500,000, deferred gains through multiple 1031 exchanges over the course of 30 years, and died with the property (or its DST replacement) valued at $3,000,000. The heirs receive the asset with a basis of $3,000,000. All previously deferred capital gains and depreciation recapture are eliminated. The heirs can sell immediately with no federal income tax liability on the appreciation that accumulated during the original investor's lifetime.
This is not a deferral. It is an elimination.
Section 1031 and DSTs: The Deferral Engine
The step-up in basis strategy only works if the investor can continuously defer taxation during their lifetime. That's where Section 1031 exchanges become central.
Under IRC Section 1031, real estate investors can defer capital gains and depreciation recapture by exchanging one investment property for another of "like-kind." As long as the exchange meets the procedural and timing requirements, no tax is due at the time of the exchange.
The IRS ruled in Revenue Ruling 2004-86 that beneficial interests in a properly structured DST qualify as "like-kind" property for Section 1031 purposes. This means an investor exiting an actively managed property can exchange into a DST, and continue to defer taxes, while transitioning from hands-on real estate to passive ownership.
DSTs are particularly well-suited to aging investors for several reasons:
Passive ownership: No tenants, no toilets, no trash
Fractional interests: A single investor can diversify across multiple DSTs
Professional management: Sponsors handle all operational responsibilities
Estate-friendly structure: Fractional interests can be divided cleanly among heirs
Putting It Together: The Full Strategy
Assembled end to end, the sequence looks like this:
Investor owns appreciated real estate with significant deferred gains
Investor executes a 1031 exchange into one or more DSTs
DST distributes income during the investor's lifetime, typically monthly
Investor may execute additional 1031 exchanges as DSTs reach full-cycle, continuing deferral indefinitely
At the investor's death, heirs receive the DST interests with a stepped-up basis
Heirs can sell or exchange with no federal income tax liability on the decedent's deferred appreciation
For advisors working with clients approaching retirement, this sequence can eliminate the tax friction that often deters late-stage real estate repositioning. The client can exit direct ownership, transition to passive income, and preserve the full deferred gain for heirs.
The 721 UPREIT Bridge
Some DSTs offer a secondary planning option: conversion to operating partnership (OP) units in a REIT through an IRC Section 721 exchange.
A 721 exchange allows DST investors, typically at the end of the DST's holding period, to exchange their beneficial interests for OP units in a REIT's operating partnership on a tax-deferred basis. OP units generally offer:
Greater liquidity than DST interests
Diversified exposure across the REIT's portfolio
Continued tax deferral during the investor's lifetime
Step-up in basis at death, preserving the same estate planning benefits
Not every DST offers a 721 option, and not every investor's situation calls for one. But for clients focused on long-term estate planning, the 721 UPREIT bridge can provide flexibility that a standalone DST cannot.
The 2026 Estate Tax Landscape
The One Big Beautiful Bill Act (OBBBA), signed into law on July 4, 2025, permanently increased the federal estate and gift tax exemption to $15 million per individual, $30 million for married couples, effective January 1, 2026. The exemption will be indexed for inflation beginning in 2027. This replaced the scheduled TCJA sunset that would have reduced the exemption to approximately $7 million.
The federal estate tax rate above the exemption remains 40%. Full details are published by the IRS in its 2026 tax inflation adjustments.
For many real estate investors, the higher exemption removes federal estate tax as a binding constraint. Several considerations remain for advisors, however:
State-level estate taxes: Many states impose estate or inheritance taxes at thresholds well below the federal exemption. Investors with property or residency in multiple states should verify state-level exposure.
Depreciation recapture elimination: The step-up in basis eliminates not only deferred capital gains but also accumulated depreciation recapture, which is taxed at up to 25% federally when recognized.
Gift tax coordination: Lifetime gifts reduce available estate exemption; strategic planning remains valuable even under the higher threshold.
Future legislative changes: While the $15 million exemption is labeled "permanent," future administrations and Congresses retain authority to modify it.
For investors whose estates fall well below the $15 million exemption, the step-up in basis strategy becomes even more powerful — decades of deferred taxes are eliminated without triggering any federal estate tax at all.
Planning Considerations for Advisors
Several practical points for advisors evaluating this strategy with clients:
Holding period alignment. The step-up only applies at death. Clients who may need to sell DST interests during their lifetime should plan accordingly, as sale during life triggers recognition of all previously deferred gains.
Spousal and community property considerations. Community property states generally allow for a "double step-up" — both halves of community property receive a stepped-up basis at the first spouse's death. This is a significant planning point in California and other community property jurisdictions.
Sponsor quality matters more over long horizons. The longer a DST is held, the more important the sponsor's operational discipline and financial stability become. For strategies that contemplate holding through death, sponsor selection is a critical due diligence factor.
Coordinate with the estate plan. Clients pursuing this strategy should work with their estate planning attorney to ensure DST interests are titled appropriately, integrated with revocable trusts where applicable, and coordinated with the overall estate structure.
Key Takeaways
The step-up in basis under IRC Section 1014 eliminates all previously deferred capital gains and depreciation recapture when assets pass to heirs at death.
Section 1031 exchanges allow real estate investors to continuously defer taxes during their lifetime, preserving the full deferred gain for the step-up at death.
DSTs qualify as like-kind property under Revenue Ruling 2004-86, allowing 1031 exchanges into passive, professionally managed real estate.
The 2026 federal estate tax exemption is $15 million per individual ($30 million per married couple), effectively removing federal estate tax as a constraint for most investors.
Community property rules, state-level estate taxes, and sponsor quality remain important planning considerations across the holding period.
About Medalist Diversified, Inc.
Medalist Diversified, Inc. (NASDAQ: MDRR) is a publicly traded DST sponsor platform focused on net-lease commercial real estate with investment-grade or near-investment-grade tenants. As a NASDAQ-listed company, Medalist files quarterly 10-Qs, annual 10-Ks, and 8-K current reports with the SEC, and is audited annually by Cherry Bekaert LLP, a PCAOB-registered public accounting firm.
Learn more at medalistdst.com or view the Medalist profile on the AltsWire alternative investments directory.
This article is for informational purposes only and does not constitute tax, legal, or investment advice. DST investments involve risk, including potential loss of principal. Investors should consult their own tax advisor, estate planning attorney, and financial professional before making any investment decision. Past performance does not guarantee future results.
