Inherit a Rental: Step-Up Wipes $150K of Recapture

The decision: Margaret’s $600,000 rental in Phoenix

Margaret is 79, widowed, and owns a single-family rental in Phoenix, Arizona that she bought in 1998 for $180,000 — allocated $30,000 to the land (non-depreciable) and $150,000 to the building. After 28 years on the 27.5-year schedule, she has claimed essentially the full $150,000 in depreciation, dropping her adjusted basis to roughly $30,000 (the land). The home is now worth $600,000. Her two children keep asking the same question: should she sell now and simplify her life, do a 1031 exchange, or just keep collecting rent?

Run the sale-during-life math first. Her total gain is roughly $570,000 over her ~$30,000 adjusted basis. Of that, the $150,000 of prior depreciation is taxed as unrecaptured §1250 gain at up to 25% — a $37,500 hit. The remaining ~$420,000 of appreciation is long-term capital gain at 15%–20%, plus the 3.8% NIIT on the portion of her income over the $200,000 single MAGI threshold. The combined federal bill lands north of $100,000 — before Arizona state tax.

Now run the hold-until-death path. Under IRC §1014, when Margaret dies, her children inherit the rental with a basis stepped up to its date-of-death fair market value — $600,000. The entire $570,000 of built-in gain, including all $150,000 of depreciation recapture, vanishes. The kids can sell the next week for $600,000 and owe essentially nothing. The decision lever is clear: for an aging owner who does not need the cash now, holding is worth more than $100,000 of erased tax.

What IRC §1014 actually does

Section 1014 is one of the largest breaks in the tax code. It says that property acquired from a decedent takes a basis equal to its fair market value on the date of death (or the alternate valuation date six months later, if the executor elects it on Form 706). This applies whether or not the estate owes any estate tax — and since the 2026 federal estate exemption is $13.99M per individual ($27.98M for a married couple with portability), the overwhelming majority of estates owe no estate tax at all and still get the full step-up.

Here is the part that surprises landlords: the step-up does not just reset the appreciation. It resets everything. The original owner’s adjusted basis — the number you get after subtracting all the depreciation you ever claimed — is irrelevant after death. The heir starts fresh at FMV. Because depreciation recapture is calculated as the difference between sale price and the depreciated adjusted basis, and that basis is replaced with current FMV, there is no recapture to calculate. The liability is not transferred to the heir; it is extinguished with the decedent.

The recapture that disappears: the numbers

The $150,000 of depreciation that fueled decades of tax-sheltered rental income is never repaid. That is not a deferral, not a partial break — it is a permanent erasure. The depreciation deductions were real and reduced Margaret’s taxes every year she owned the property, and the recapture that would normally claw a portion of that back simply never happens.

The community-property fork: half step-up vs. full step-up

For married couples, the size of the step-up depends entirely on which kind of state you live in — and the gap is enormous.

• Common-law states (most of the country): when the first spouse dies, only the decedent’s half of a jointly-owned rental steps up. The surviving spouse keeps their original (low) basis on their half. On Margaret’s $600,000 rental, the survivor would step up half to $300,000 and keep $15,000 on the other half — new basis ~$315,000, leaving ~$285,000 of gain and half the depreciation recapture still live.
• Community-property states (CA, AZ, ID, LA, NV, NM, TX, WA, WI): under IRC §1014(b)(6), when one spouse dies the entire community-property asset steps up — both halves. The survivor’s new basis is the full $600,000. All $150,000 of recapture and all the appreciation are erased on the first death, not just the decedent’s half.

Margaret lives in Arizona, a community-property state. When her late husband died, the rental had already received a full double step-up under §1014(b)(6) — which is part of why her basis story is favorable. For couples in common-law states holding highly appreciated rentals, this is the single biggest reason to consider a community-property trust or, for the right facts, establishing domicile in a community-property state. The difference between a half step-up and a full step-up on this property is roughly $285,000 of basis — worth more than $70,000 in eventual tax.

The heir gets a brand-new depreciation schedule

The step-up does not just protect the heir on sale — it hands them a fresh tax shelter if they keep renting. Under IRC §168, the heir allocates the stepped-up FMV between land (non-depreciable) and building, then starts a new 27.5-year straight-line schedule on the building portion.

1. Step-up basis: $600,000 (date-of-death FMV).
2. Allocate to land (non-depreciable): say $120,000 (20%).
3. Depreciable building basis: $480,000.
4. Annual depreciation: $480,000 ÷ 27.5 = ~$17,450/year of new deductions.

The decedent’s depreciation schedule does not carry over. The heir is not picking up Margaret’s remaining basis or her remaining recovery period — they start over at a higher number. This is the opposite of a gift during life, where the recipient takes the donor’s carryover basis and inherits the depreciation history and recapture exposure (IRC §1015). Inheritance resets; gifting carries over. That distinction alone can be worth six figures.

1031 exchange vs. holding for the step-up

A common instinct is to 1031-exchange the rental to avoid tax. But a 1031 exchange (IRC §1031) only defers — it does not erase. The deferred gain and recapture roll into the replacement property’s basis and stay there until a taxable sale. If you exchange and then sell later, the bill comes due, often larger because the replacement property has appreciated too.

The elegant play for an aging owner is what practitioners call “swap till you drop”: keep 1031-exchanging into new properties during life (deferring tax and trading into more manageable assets if you like), then die still holding. At death, §1014 steps up the basis of whatever you hold — erasing every dollar of deferred gain and recapture that accumulated across all those exchanges. Deferral during life plus erasure at death equals zero tax ever paid on the gain.

What most people get wrong

The most common and costly misconception is that depreciation recapture “follows the property” to the heir. It does not. Recapture is a function of the gap between sale price and adjusted basis. Once §1014 replaces the adjusted basis with date-of-death FMV, the gap closes and there is nothing to recapture. People assume the IRS must eventually collect on all that depreciation — but the tax code deliberately lets it die with the owner.

A second myth: that you must owe estate tax to get the step-up. You do not. The step-up under §1014 is independent of estate tax. An estate worth $800,000 — far below the $13.99M exemption — pays zero federal estate tax and still gets a full basis reset on every appreciated asset. Estate tax and income-tax basis step-up are two separate systems.

A third trap: the entity structure can break the step-up. If the rental is held in an S-corporation, only the heir’s stock basis steps up — the corporation’s inside basis in the real estate does not. The depreciation recapture stays trapped inside the S-corp, and a sale by the corporation still triggers it. By contrast, property held individually, in a single-member LLC (disregarded), or in a partnership (with a §754 election) gets an inside basis step-up on the real estate itself. Never put long-hold appreciating rentals inside an S-corp if a step-up is part of the plan.

The documentation that makes the step-up stick

The step-up is automatic by statute, but the heir must prove the date-of-death FMV to claim the higher basis on a future sale. Sloppy or missing valuation is where heirs lose money:

• Get a qualified appraisal as of the date of death. A retroactive appraisal is acceptable and routine, but order it close to the death date while comparables are fresh. This appraisal is the heir’s evidence of the stepped-up basis — it directly determines how much gain (if any) shows up on a later sale.
• Allocate between land and building. The appraisal or a tax preparer should split the FMV so the heir can start the new depreciation schedule on the building only. The land allocation also matters if the heir later sells.
• Consider the alternate valuation date. If the property dropped in value in the six months after death, the executor can elect alternate valuation on Form 706 — but only if it lowers both the gross estate and the estate tax, and only for estates that file 706. Most modest estates use date-of-death value.
• For partnerships, make the §754 election. Without it, the inside basis of partnership-held real estate does not step up even though the partnership interest does. This is a frequent, expensive oversight.

The decision lever

If you are an aging landlord sitting on a highly appreciated, heavily depreciated rental, the §1014 step-up is the most powerful exit you have — and it costs nothing but patience. Selling during life voluntarily writes a check the tax code would otherwise tear up at your death. The lever is simple: if your estate is comfortably under the $13.99M federal exemption, you do not urgently need the sale proceeds, and your heirs want the asset (or the clean cash from selling it post-step-up), hold the property. Let the date-of-death basis reset erase the $150,000 of recapture and the entire built-in gain. If you want to keep investing in the meantime, 1031 your way through life and still die holding — the step-up catches it all at the end. The single mistake that forfeits this is selling early, or trapping the property in an S-corp where the inside basis never resets.