Estate Tax Planning for Real Estate Investors

The estate tax basics

The federal estate tax applies to estates exceeding the applicable exclusion amount — approximately $13.99 million per person (2025), or $27.98 million for a married couple using portability. Property included in the estate is taxed at a flat 40% rate on the excess.

Real estate is included at its fair market value at death, which for appreciated rental portfolios can be substantial. Most families below the exemption threshold owe no federal estate tax, but some states have lower thresholds — several states tax estates above $1–$2 million. The federal exemption is scheduled to roughly halve in 2026 if Congress does not act to extend the current levels.

The step-up: income tax benefit, estate tax cost

The same appreciation that triggers estate tax also generates the step-up in basis that eliminates income tax on that appreciation. This creates a trade-off: the step-up strategy (holding appreciated rentals until death) eliminates all income tax on the gain but includes the FMV in the estate — potentially taxed at 40%.

The math: if your combined income tax on gain would be 35% and you pay 40% estate tax instead, you're worse off with the step-up strategy for the over-threshold portion. For estates well under the exemption, the step-up is pure gain — zero estate tax and zero income tax on decades of appreciation.

Common planning strategies

Several strategies reduce estate tax while preserving some or all of the step-up. A qualified personal residence trust (QPRT) removes a personal home from the estate at a discounted value. A grantor retained annuity trust (GRAT) can transfer appreciation in excess of the hurdle rate out of the estate tax-free.

For rental portfolios, a family limited partnership (FLP) or LLC can apply minority and lack-of-marketability discounts (typically 20–40%) to the gifted interests, transferring more value using less of the lifetime gift exemption. Charitable remainder trusts allow a sale of appreciated property, income during life, and a charitable deduction. Each strategy has its own complexity and risk — model them against the doing-nothing baseline.

2026 update: the exemption made permanent

The sections above reflect the pre-2026 law, under which the elevated exemption was scheduled to sunset after 2025. That sunset did not happen. Under the tax legislation enacted in 2025, the federal estate, gift, and generation-skipping transfer tax exemption was set at $15 million per person ($30 million per married couple) for 2026, indexed for inflation thereafter, and made permanent — eliminating the scheduled reversion to roughly $7 million. The top estate tax rate remains 40%.

Practically, this means far fewer estates owe federal estate tax than the earlier sunset scenario implied. For most investors the planning emphasis shifts back toward capturing the income-tax step-up rather than racing to move assets out of the estate. Investors whose net worth may approach the $15 million threshold still benefit from the discount and trust strategies below, but the urgency created by the pending sunset has eased. Always confirm the current-year indexed figure at irs.gov before acting.

A worked example: step-up vs. estate tax

Consider a $6 million rental portfolio with a $1.5 million adjusted basis, held by a single investor whose total estate is $10 million — below the $15 million exemption. At death the entire estate passes estate-tax-free, and the portfolio's basis steps up to $6 million, erasing $4.5 million of built-in gain and all accumulated depreciation recapture. Selling shortly after death produces essentially no income tax — a pure win with no offsetting estate tax.

Now change the estate to $25 million. The roughly $10 million above the $15 million exemption is taxed at 40%, producing about $4 million of estate tax. Here the step-up still eliminates income tax on the appreciation, but the estate tax on the excess is now the dominant cost, and lifetime gifting, valuation discounts, and trust strategies become genuinely worthwhile rather than optional.

State estate and inheritance taxes

Federal exemptions are generous, but roughly a dozen states plus the District of Columbia impose their own estate tax, and a handful impose an inheritance tax (paid by the heir), several with exemption thresholds as low as $1–$2 million — far below the federal amount. Rental real estate is generally taxed by the state where the property is located, so an investor domiciled in a no-estate-tax state can still owe state estate tax on an out-of-state rental.

This makes the location of each property, not just your own residency, part of the estate-tax picture. Map every property against its state's rules; in some cases owning real estate through an entity can change the situs analysis, though this is fact-specific and warrants professional advice.

Liquidity: paying tax on an illiquid asset

Federal estate tax is generally due within nine months of death, in cash — a problem when the estate is mostly buildings. Options include IRC Section 6166, which lets estates with a large closely held business interest pay the attributable estate tax in installments over as long as 14 years; a forced sale of a property (often at a discount under time pressure); or pre-funding the liability with life insurance.

Investors with concentrated, appreciated, hard-to-sell portfolios should plan liquidity before death so heirs are not forced to dump the best assets at fire-sale prices to cover the tax. Liquidity planning is often the difference between heirs keeping the portfolio and being forced to break it up.

The trust trade-off: estate exclusion vs. lost step-up

Moving a rental into an irrevocable trust during life can remove future appreciation from the taxable estate — but assets given away in an irrevocable trust generally do not receive a stepped-up basis at death, because they are no longer in the estate. That is the core trade-off: exclude the asset and keep its appreciation out of estate tax, but the heirs inherit your carryover basis and its built-in gain.

For estates comfortably under the $15 million exemption, this trade is usually a loser — you would surrender a valuable step-up to avoid an estate tax you would not owe anyway. The calculus flips only for estates large enough that the 40% estate tax on future appreciation exceeds the income tax the lost step-up would have saved.

Life insurance and the ILIT

An irrevocable life insurance trust (ILIT) holds a life insurance policy outside the estate, so the death benefit is both income-tax-free and estate-tax-free, and it provides heirs the liquidity to pay any estate tax without selling property. For an investor whose wealth is concentrated in illiquid rentals and whose estate exceeds the exemption, an ILIT is a common tool: the tax-free insurance proceeds cover the estate-tax bill, letting the family keep the real estate intact and still benefit from its stepped-up basis.

Portability: do not waste the first spouse's exemption

A married couple can shelter roughly $30 million combined, but only if they preserve the first spouse's exemption through portability. When the first spouse dies, the executor must file a federal estate tax return (Form 706) and elect to transfer the deceased spousal unused exclusion (DSUE) to the survivor — even if no tax is owed and no return would otherwise be required.

Skip the election and the first spouse's unused exemption is lost forever, potentially exposing millions to the 40% tax at the second death. For any estate anywhere near the threshold, filing Form 706 solely to elect portability is inexpensive insurance against a far larger bill later. The DSUE, once elected, is added to the surviving spouse's own exemption and used before it.

The annual gift exclusion: shrinking the estate quietly

Before reaching for trusts, remember the annual gift tax exclusion — $19,000 per recipient in 2025 (indexed each year), or $38,000 for a married couple splitting gifts. Gifts within the exclusion use none of your lifetime exemption and file no gift tax return, yet they steadily move value out of the estate. A couple with three children and their spouses can move well over $200,000 a year this way.

For real estate, this often means gifting fractional interests in a property or in an LLC that holds it, year after year. The catch is basis: a lifetime gift carries your carryover basis to the recipient, so they inherit the built-in gain rather than a stepped-up basis. Gifting is powerful for estates above the exemption where estate-tax savings outweigh the lost step-up, and usually the wrong move for estates below it.

How the IRS values real estate in an estate

Real property is included at its fair market value on the date of death — or, if the executor elects the alternate valuation date, its value six months later (available only if that election lowers both the gross estate and the estate tax). For anything but the simplest holdings, that value comes from a qualified appraisal, not a tax-assessment figure or a rough guess, because the appraised value also becomes the heirs' stepped-up basis.

This dual role makes the appraisal worth getting right. A defensibly high appraisal raises the estate value (bad if you owe estate tax) but also raises the heirs' basis (good, because it reduces future income tax on a sale). For estates below the exemption where no estate tax is due, there is no estate-tax downside to a well-supported higher value — it simply maximizes the step-up. Keep the appraisal with the estate records; the IRS can challenge valuations for years.

The generation-skipping transfer tax

Investors who want to pass real estate to grandchildren must reckon with the generation-skipping transfer (GST) tax, a separate 40% levy on transfers that skip a generation. It has its own exemption, equal to the estate-tax exemption (about $15 million per person for 2026), and it is not portable between spouses — each spouse's GST exemption must be affirmatively allocated, usually on a gift or estate tax return.

A dynasty trust holding rental property can leverage the GST exemption to shelter a portfolio across multiple generations, keeping the assets out of each descendant's taxable estate. This is advanced planning that belongs with an estate attorney, but the key point for investors is simple: if grandchildren are in the plan, the GST exemption must be allocated deliberately, or a second layer of 40% tax can apply on top of the estate tax.

Coordinating the plan with entities and title

How you hold each property interacts with the estate plan. Property titled jointly with right of survivorship passes automatically to the co-owner and can complicate exemption planning; property in a revocable living trust avoids probate but stays fully in your taxable estate (and keeps the step-up); property in an LLC or family limited partnership enables valuation discounts and orderly transfers of fractional interests.

Community-property states add a valuable twist: in those states, both halves of community-property real estate generally receive a full step-up at the first spouse's death, not just the deceased spouse's half. Investors who move between states, or who hold property across several, should map title and entity structure against both the estate-tax rules and this basis treatment, ideally well before any transfer is hard to unwind.

Frequently asked questions

Sources

• IRS Publication 527 — Residential Rental Property

Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.

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