Completing a 1031 exchange after selling an investment property can bring many potential tax benefits, such as deferral of any capital gains and depreciation recapture taxes incurred from the sale of your original investment property.
There are several important stipulations that must be met with any 1031 exchange, however, in order for taxpayers to recognize deferral of capital gains. Foremost among these requirements is that the exchanged property must be held for business use or as an investment property -- you can’t exchange a rental property for a condo on the beach and then move into it (at least not right away). Investors must demonstrate that their swapped properties are being held as investments in order to satisfy exchange requirements.
While you can gift a 1031 exchange property, you must pay strict attention to exchange timelines so that you don’t run the risk of disqualifying the exchange. Here’s a rundown of how it works.
1031 Exchange Holding Period
Investors new to the 1031 exchange process often want to know how long they must hold their swapped investment assets. There are two things to take into consideration: timing and intent.
Although the Internal Revenue Service does not provide concrete guidance on timelines about holding periods, there have been some key IRS rulings that provide insight into the issue of timing and intent in regards to 1031 exchanges.¹ One way to avoid an audit and potential disqualification is to hold an investment property for at least two years after completing an exchange. This suggested “safe harbor” period is generally sufficient to satisfy the timing requirement -- provided you’ve gleaned some type of rental income from the asset during those two years.
That last harkens back to intent. Exchanged properties, regardless of asset class or property type, must be held for productive use in trade or business, or as an investment. Assets acquired for personal use, or to be gifted to someone else, fail to meet this requirement -- that’s why you can’t move into that beachside condo right away. You had better rent it out a few years before making it a personal residence or risk failure on either the holding or intent requirements.
Gifting a 1031 Exchange Property
You can gift a property acquired through a 1031 exchange, with some caveats.
First, satisfy the holding requirement. Don’t gift the asset immediately after acquiring it, or you’ve clearly not completed the exchange with the intent to hold the asset as an investment property. Secondly, hold the property for at least two years and derive rental income from it before gifting it to further meet the holding and intent requirements. If you have demonstrated both, you should be able to gift a 1031 asset without incurring an IRS audit of your exchange.
Federal taxation experts writing for the Real Property, Trust and Estate Law Journal point to key IRS rulings rather than the tax code itself to identify the points made above.² While these rulings shouldn’t be considered binding tax law, they do provide guidance on how investors should proceed with their 1031 exchanges in order to avoid disqualification.
1. Hellwig, Brant J. “THE HOLDING INTENT REQUIREMENT FOR PROPERTY TRANSFERRED IN A SECTION 1031 EXCHANGE.” Real Property, Trust and Estate Law Journal, vol. 45, no. 4, American Bar Association, 2011, pp. 635–75, http://www.jstor.org/stable/23058671
2. Brant J. Hellwig, Professor of Law, Washington & Lee University Law School, https://law.wlu.edu/faculty/full-time-faculty/brant-hellwig
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.