Trusts, Estates, and Fiduciaries

That shift changes the analysis in a way the tax rules do not capture. A fiduciary who executes a technically valid exchange may still have breached a duty, and a fiduciary who declines a valid exchange may have breached a different one. This chapter closes Part V by taking that problem seriously.

22.1 Exchanges by estates

An estate is a separate taxpayer that succeeds to the decedent's property. It may hold property for investment and may exchange it, and there is nothing structurally unusual about an estate as an exchanging taxpayer.

What is unusual is that the exchange is usually pointless.

Property acquired from a decedent generally takes a basis equal to its fair market value at the date of death.¹ Where that adjustment applies, the appreciation accrued during the decedent's life is eliminated rather than deferred. An estate that sells shortly after death typically realizes little or no gain, and there is correspondingly little to defer.

The practical consequences are three.

An estate contemplating an exchange should begin by computing the gain. Where the basis adjustment has eliminated it, the exchange imposes cost, deadline risk, and constrained property selection in exchange for deferring nothing.

The analysis differs where the property has appreciated materially since death, where the estate has held for a substantial period, or where the basis adjustment is unavailable or partial. In those cases an exchange may be worth doing on ordinary principles.

The situation from 18.4, in which a taxpayer dies mid-exchange, is distinct and should not be confused with this one. There the exchange is already underway and the question is whether it may be completed. Here the question is whether it should be started at all, and the answer is usually no.

22.2 Fiduciary duty and the decision to exchange

Where a trustee or personal representative holds property for beneficiaries, the exchange decision is a fiduciary act, and the governing standards come from trust law rather than from the Code.²

Four features of a section 1031 exchange sit awkwardly with ordinary fiduciary standards, and each should be considered explicitly rather than assumed away.

Deadlines compress deliberation. The forty-five day identification period examined in Chapter 25 requires a decision on a schedule that does not accommodate beneficiary consultation, appraisal, or the reflection a prudent investor standard contemplates. A fiduciary who begins an exchange has committed to deciding quickly.

Property selection is constrained. The replacement property must be real property, must be identified within the period, and must be available. A fiduciary otherwise obliged to diversify is, for the duration, restricted to a single asset class. Where the governing instrument or applicable statute imposes a duty to diversify, an exchange may sit in tension with it.

The benefit and the burden may fall on different people. Deferral advantages whoever holds the property when the deferred gain would otherwise be recognized. Where income beneficiaries and remainder beneficiaries differ, an exchange can shift value between them. A trustee should understand which beneficiary the transaction favors before executing it.

Failure is expensive and asymmetric. A failed exchange does not restore the status quo. It produces a taxable sale, often with proceeds tied up until the exchange period closes, and the tax is borne by the trust. The downside is not symmetrical with the upside.

None of this counsels against fiduciary exchanges. It counsels documentation. A memorandum written before the relinquished property closes, recording the gain computation, the beneficiaries considered, the alternatives weighed, and the reason the exchange was thought prudent, is inexpensive at the time and close to indispensable if the decision is questioned later.

Authority to exchange should also be confirmed rather than presumed. Instruments granting a trustee power to sell and to invest do not necessarily authorize a transaction that encumbers the trust with deadlines and a specific-property requirement, and the safer course where the instrument is silent is to obtain beneficiary consent or court approval.

22.3 Charitable structures as an alternative

Where a client's objective is to exit an appreciated property without an immediate tax, section 1031 is one of several instruments, and it is not always the best one. Two charitable structures deserve mention because they solve adjacent problems and because clients often reach for an exchange when they want something else.³

A charitable remainder trust permits an owner to contribute appreciated property to a trust that sells it, with the trust's tax exemption avoiding immediate recognition, in return for a retained income stream and a charitable deduction for the remainder value. Compared with an exchange, it converts real property into a diversified income interest, which is precisely what an exchange cannot do.

A bargain sale to a charity splits the transaction into a sale portion and a contribution portion, producing partial recognition and a deduction.

Three points frame the comparison.

The structures are not interchangeable. An exchange preserves ownership of real property and defers gain indefinitely. A charitable structure surrenders the property permanently and produces income and a deduction. A client who wants to keep investing in real estate does not want a charitable remainder trust.

Sequencing forecloses options. Once relinquished property has closed into a qualified intermediary, the charitable alternatives are materially harder to execute. The comparison belongs at the beginning of the engagement.

Combinations exist and are technical. A contribution of an interest in property followed by an exchange of the retained interest, or an exchange followed by a later charitable transfer, can be structured, but both interact with the holding requirement of Chapter 12 and with the anti-abuse doctrines of Chapter 42.

The interaction of deferral with the basis adjustment at death, which is the third alternative and often the strongest, is developed at Chapter 46.