What the Step-Up Actually Does Inside a Passive Real Estate Fund

When an investor dies, the tax basis of most assets in the estate is reset to fair market value at the date of death, or at an alternate valuation date if the estate elects one. Unrealized gains disappear for the heir, and unrealized losses disappear as well, because the reset works in both directions. This article uses “step-up” as shorthand for that reset, even though the adjustment can be downward. Some assets do not reset, including retirement accounts and other income owed to the decedent, and assets that sit outside the estate generally do not either.

For publicly traded stocks, ETFs, and mutual funds, the process is simple. The value is observable on the date of death, the heir's basis in the shares becomes that value, and a sale soon afterward produces little or no gain or loss. The decedent owned one thing, and the reset applies to that one thing.

Assets that are not publicly traded are less straightforward, because what the decedent owned, and who controls what happens next, varies by structure. Real estate shows this in three common forms.

• Directly owned alone: The property itself resets. The heir controls the valuation, the timing of any sale, and the new depreciation schedule.
• Directly owned through an LLC with peers: When the LLC is taxed as a partnership, the interest resets, and the outside basis and inside basis described below apply. Decisions are shared among a small group of owners.
• Held as a limited partner in a passive fund: The interest resets, but the general partner controls property sales, the basis election, and often the redemption terms. The step-up depends on decisions the heir does not make.

Two questions separate these forms. The first is whether the decedent owned the asset itself or an interest in an entity that owns it. Public securities and sole direct ownership involve one basis, and the reset applies to it. An LLC with peers and a passive fund involve two, the heir's basis in the interest and the entity's basis in the property. The reset reaches only the first by default.

The second question is who decides what happens next. In the first group, the heir does. In an LLC with peers, a small group of owners decides together, and in a passive fund the general partner decides. An LLC with peers is therefore the closest relative of the passive fund, sharing its tax structure but not its control. Directly owned property is closer to public stock in tax structure, though it has no market price and is far less liquid.

The rest of this article focuses on the third form and assumes familiarity with depreciation, passive losses, and Schedule K-1 reporting. Many of its partnership mechanics may also apply to an LLC with peers that is taxed as a partnership, depending on the operating agreement, with the owners rather than a sponsor making the decisions. Delaware Statutory Trusts and the 1031 exchange path into operating partnership units, which are partnership interests as well, are covered in A Structured Exit From Directly Owned Real Estate. That article addresses the step-up for those units only briefly.

Outside Basis and Inside Basis

Two separate bases matter in a fund, and the rest of this article refers to them by name.

Outside Basis

Outside basis is the heir's tax basis in the partnership interest itself. It generally equals the fair market value of the interest at the date of death, plus the heir's share of the partnership's liabilities. In a leveraged real estate fund, the liability share can be a large part of it. Outside basis determines the gain or loss when the interest is redeemed or sold. It also limits how much of the fund's losses the heir can deduct and how much cash can be distributed tax-free.

Inside Basis

Inside basis is the fund's own tax basis in the properties it holds. It sets the fund's depreciation deductions and the gain the fund reports when it sells a property, and that gain flows through to the partners on the Schedule K-1. Inside basis does not change at death by default, so the fund keeps depreciating the buildings on the old figures.

How the Two Diverge at Death

The heir receives a new outside basis while the fund reports on its old inside basis. The partnership tax year also closes for the deceased partner at death, which splits that year's allocations between the decedent and the successor. Nothing on the K-1 shows the new outside basis. The date-of-death value exists only in the records an executor or heir maintains.

The Section 754 Election

A fund can close the gap between inside basis and outside basis by making a Section 754 election. With the election in effect, the heir receives a basis adjustment on the fund's property that is specific to that heir and leaves the fund's own basis unchanged.

The adjustment is allocated between assets that would produce ordinary income on a sale and assets that would produce capital gain. That allocation can reduce ordinary recapture as well as capital gain. Ordinary recapture is the portion of past depreciation taxed at ordinary rates on a sale, typically from equipment and fixtures, while depreciation on the buildings is recaptured at rates up to 25 percent. A positive adjustment is also depreciated as though newly placed in service, which gives the heir a fresh depreciation shield.

The election is made with the partnership return for the year of the transfer, and it then applies to every later transfer and distribution until it is revoked. That permanence is one reason a sponsor may decline to make it, since each later transfer requires separate tracking. Whether and when a sponsor makes the election is typically governed by the operating agreement.

The regulations also contemplate written notice from the heir to the partnership, due within one year of the death for a transfer at death. The partnership is not required to compute an adjustment until it receives that notice. A separate rule requires an adjustment when a partnership has a substantial built-in loss, which is the reverse of the appreciated property case discussed here.

Four Ways a Fund Interest Is Resolved After a Death

The step-up reaches the heir only when something happens to the interest. Four common paths produce different results.

• Redemption from an evergreen fund: The fund pays out at stated net asset value, which is typically close to the date-of-death value when redemption follows soon after the death. The step-up is realized at once and little gain or loss remains. A redemption may still produce ordinary income under Section 751 for the heir's share of recapture-type assets, with an offsetting capital loss. Redemption limits and net asset values that may trail market prices are the main tradeoffs.
• Property sale with distribution: After the fund sells a property, the K-1 reports the gain using the fund's old basis. The offsetting loss on the interest does not appear until the interest is liquidated.
• Closed-end fund wind-down: Sales occur property by property over several years, and the final payout can arrive well after the largest gains were taxed. Sales concentrated in a single year line the gain and the loss up far better.
• Sale of the interest: A secondary sale is often priced at a discount and may still trigger ordinary income under Section 751 for recapture-type assets. It gives the heir control over timing at a cost in price.

Tracing Basis Through a Death and a Sale

Following a single interest from purchase to final payout shows where outside basis and inside basis separate. An investor puts $100,000 into one property, and the investor's share of the property debt is $230,000. The investor dies in year 6 with the interest valued at $150,000, and the property is sold in year 7 for roughly the value placed on the interest.

• During the hold: A $40,000 first-year loss from bonus depreciation lowers outside basis even if passive rules suspend it. A cash-out refinance in year 5 raises the debt share by $40,000 and pays out $40,000, so outside basis does not change.
• At the death: The new outside basis is the $150,000 value plus the $270,000 debt share, or $420,000. The K-1 capital account is $0, and nothing on the K-1 records the $150,000 difference.
• At the sale: The K-1 reports a $150,000 gain on the fund's old basis. When the loan is repaid, the debt share falls to zero, which reduces outside basis to $300,000. The final $150,000 payout leaves $150,000 of basis unused, which is a capital loss.

The $150,000 gain and the $150,000 loss are the same step-up appearing twice. Whether the loss is useful depends on what it can offset, which is the subject of the next section.

The Mismatch

Without a Section 754 election, three mismatches follow from the gap between outside basis and inside basis.

• Character: Gain allocated on the old basis keeps its original character, which can include ordinary recapture and building recapture taxed at up to 25 percent. The offsetting loss is a capital loss on the interest, and it is recognized only when the final payout consists of nothing other than cash, unrealized receivables, and inventory.
• Timing: The gain is reported in the year the fund sells the property. The loss arrives in the year of the final payout, which can be later. The fund may also retain sale proceeds for debt reduction or reserves, so the heir can owe tax on the gain without receiving the cash, sometimes called phantom income. The capital stays in the fund until the final payout, so the tax may have to be paid from other sources.
• Limits: A capital loss offsets capital gains in full, but only $3,000 a year of any excess can offset ordinary income. Ordinary recapture is therefore largely taxed even when a larger capital loss exists.

Limits and Tradeoffs of the Step-Up

The step-up has boundaries, and how much loss a fund generates during life affects how much of it reaches the heir.

What Does Not Step Up

• Ordinary recapture: Depreciation recaptured as ordinary income, including equipment, fixtures, and depreciation beyond straight-line, generally remains in the gain unless a Section 754 election addresses it.
• Growth after the death: Appreciation after the date of death is taxed in the normal way.
• Suspended losses: Passive losses suspended at death are allowed on the decedent's final return only to the extent they exceed the basis step-up. Losses within the step-up are not allowed as a deduction, and heirs and trusts generally begin with none of their own.
• Gifted interests: An interest given away during life generally keeps the giver's basis in the recipient's hands. Assets in an irrevocable trust generally do not reset at the grantor's death unless they are included in the estate. This is a tradeoff against estate tax planning, and the estate planning attorney and CPA typically weigh it together.
• Discounted value: If an illiquid interest is appraised below its share of the property, the step-up reaches only that lower value.

Shield Now, Step-Up Later

Real estate funds differ in how much loss they generate early in the hold. Higher leverage, bonus depreciation, and cost segregation increase the early passive losses, while lower leverage and a slower depreciation schedule reduce them. Both ends of that range are legitimate choices, and each interacts differently with a death.

• Larger early losses: These shelter more passive income during life. They also leave more recapture-type gain at exit and more suspended losses that can lapse at death.
• Smaller early losses: These shelter less income during life. They leave less recapture and fewer suspended losses to forfeit, so more of the step-up reaches the heir as intended.

Neither approach is better in every case. The right balance depends on how much passive income an investor can absorb, how long the interest is likely to be held, and how likely it is to be held at death.

Before the Death

Suspended passive losses are treated differently depending on how the interest ends. At death, they are allowed only to the extent they exceed the basis step-up, which in an appreciated fund is often little or none. In a fully taxable disposition to an unrelated buyer during life, the suspended losses are generally released, subject to conditions, and can offset any income, including wages and retirement account withdrawals.

That lifetime route has a cost. A sale during life triggers the gain and recapture that a step-up at death would have reduced, so it trades one tax result for another. Investors with large suspended losses and a long expected hold may weigh the two paths before a sale is made, together with a CPA.

Estate Size and Who Holds the Interest

The size of the estate and the type of holder both change how the step-up plays out.

Valuation and Estate Tax

For an illiquid fund interest, the date-of-death value typically comes from the sponsor's net asset value statement, an appraisal, or both. That value sets the heir's basis, so it determines how much of the gain the step-up offsets.

Estate size changes whether a lower value helps or hurts. Below the current federal estate tax exemption per person ($15 million in 2026), no federal estate tax is owed, and a discount only reduces the step-up. Above it, the top federal estate tax rate can make a discount more valuable than the step-up it costs.

Near the exemption, the choice is closer. Growth in the estate, later gifts, or a change in the exemption can move it across the line in either direction, so the analysis is typically revisited as values change.

When an estate files a return and the inclusion of the property increases estate tax, the heir's basis generally cannot exceed the value reported there. Estates below the filing threshold are generally not required to furnish the beneficiary statements that enforce this rule.

Ownership form also matters. Community property generally receives a step-up on both halves, while spouses holding property jointly generally receive it on the decedent's half.

Trusts as Holders

This section applies to irrevocable trusts that are taxed as separate taxpayers, often called non-grantor trusts. A revocable trust becomes irrevocable when the grantor dies, and from that point it generally files as a separate taxpayer as well. A trust whose income is taxed to its grantor under the grantor trust rules is a different case and is not covered here.

An irrevocable trust that retains income reaches the top federal bracket at a much lower level than an individual. The income level at which that bracket begins is set each year ($16,000 for 2026), and the net investment income tax (3.8 percent in 2026) applies to undistributed investment income above the same level. Income that a trust distributes to beneficiaries is generally taxed differently, depending on the trust's terms.

Irrevocable trusts also generally begin with no suspended passive losses, so nothing absorbs the ordinary recapture described above. How a trust treats gain and income is a matter for the trustee and the estate planning attorney. The rules differ by type of trust, and this section is only a high-level summary.

State Tax Treatment

State rules add a further mismatch. Some states tax a nonresident's share of the gain a fund reports from property located in the state. In some states, a loss on the interest itself follows the heir's home state, because a partnership interest can be treated as intangible property of the owner's residence.

Other states may instead look through the interest to the partnership's in-state assets, which can change the result. Depending on the states involved, an heir who lives in a state without an income tax can owe the property state tax on gain reported on the old basis. No offsetting loss may exist in any state.

Composite returns filed by a sponsor are often computed from partnership-level figures and do not reflect an individual heir's basis. State rules change frequently and vary considerably, so the analysis typically requires a CPA familiar with each state involved.

Where the New Basis Is Recorded

Because the K-1 keeps reporting the old figures, the heir's own records are the only continuing source of the new basis. Five items typically anchor them.

• Date-of-death value: The sponsor's net asset value statement or an appraisal, with the valuation date and method.
• Debt share at death: The partner's share of liabilities, reported in Item K1 of the K-1, which is added to the date-of-death value to give outside basis.
• Capital account at death: The capital account on a tax-basis method, reported in Item L of the final K-1, which marks how far the K-1 sits from the heir's basis.
• Suspended losses: The passive loss carryforward at death, shown on Form 8582, since the decedent's final return allows only the portion above the step-up.
• Section 754 status: The written notice to the partnership and the sponsor's confirmation of whether the election was made.

Each later K-1 then moves the new basis as it moves any basis. Income and contributions increase it, while distributions, losses, and decreases in the debt share reduce it. A running record updated each year is what allows the final payout to be reported correctly. Without one, a loss like the $150,000 above can be missed, because a return preparer working from the K-1 alone does not see it.

How the Structures Compare

The table below compares the common structures qualitatively, assuming no Section 754 election is made.

Qualitative comparison only. A Section 754 election, where a sponsor makes one, can reduce the character and timing mismatches.

• Evergreen funds: Redemption gives the heir control over when the step-up is realized, and redeemable interests may carry less valuation discount. Redemption limits, net asset values that may trail market prices, and recurring fees are the offsetting costs.
• Closed-end funds: A single portfolio sale lines up the gain and the loss in one year. Sales spread across several years separate them, and the heir has little control over timing.
• Single-asset syndications: The sale and the final payout typically occur in the same year, which limits the timing mismatch. The interest is illiquid and may carry a larger valuation discount.

Each advantage and cost depends on the fund's documents. Every structure leaves open the question of the sponsor's approach to the Section 754 election.

Questions for the Sponsor

Several of the outcomes above turn on terms that sit in the fund's documents rather than in the tax rules. The offering memorandum and operating agreement are the usual starting points. An investor can ask these questions before committing capital, and an executor or heir can ask them afterward.

• Section 754 election: Whether the fund has made one, makes one on request, or declines, and what the operating agreement says about it.
• Valuation: How and how often net asset value is set, and whether the sponsor will provide a date-of-death statement.
• Redemption at death: Whether an heir may redeem at stated value, and any limits, queues, or fees that apply.
• Transfer requirements: The documents needed to retitle the interest to an estate, trust, or heir, and the typical processing time.
• Sale sequencing: The planned timing of property sales and the final distribution, which sets the gap between the gain and the loss.
• K-1 reporting: How the partner's share of liabilities (Item K1) and the capital account (Item L) are reported, and when K-1s typically arrive.

Execution and Coordination

None of the steps above is carried out from an article alone, and each pulls in a different professional. If the investor who holds a fund interest dies unexpectedly, three things shift at once. Custody and control over redemption timing move to the executor or successor trustee, who typically provide documentation to the sponsor before the interest can be retitled or redeemed. The tax position changes as well, because the partnership year closes for the decedent and a new basis begins that the K-1 does not show.

• Estate Planning Attorney: Typically coordinates how the interest is titled, confirms the sponsor's transfer requirements, and works with the executor on valuation and any estate tax return.
• Trustee: Typically holds title when the interest sits in a trust, receives the K-1s, and manages distributions and the trust's own tax filings.
• Investment Manager: Typically tracks the fund's redemption terms and liquidity, obtains the sponsor's date-of-death valuation, and coordinates the timing of a redemption against the heir's other capital gains.
• CPA: Typically records the date-of-death value and the heir's outside basis, identifies any interest given away during life that keeps a carryover basis, confirms the sponsor's Section 754 position, gives timely written notice to the partnership, and prepares the federal and state returns, including the year-of-death allocation.

Because the K-1 does not display the stepped-up basis, the CPA's records and the heir's own files are typically the only place the new basis is documented.

The rules in this area are technical, vary by structure and by state, and change over time, and the examples here are simplified. Each point is typically confirmed with a CPA and an estate planning attorney before it is relied on.