Can You Rent To A Relative In A 1031 Exchange?

Posted Sep 11, 2023

Can You Rent To A Relative In A 1031 Exchange?

Can a property acquired in a 1031 exchange be rented to a family member? The answer, as per the tax court, is yes. However, to ensure that the transaction complies with IRS guidelines, certain key criteria must be met. Primarily, the rent set for the property should align with the fair market value appropriate to its location. Additionally, a formal, written rental agreement is necessary, and the exchanger must diligently enforce its terms, particularly those pertaining to the punctual payment of rent. With these steps, a 1031 exchange involving rental to a family member can be conducted successfully. 

Let’s take a closer look at how to complete a 1031 exchange rental to a family member. 

3 Considerations for Renting a 1031 Exchange Property to A Family Member 

If you want to rent your 1031 exchange rental to a family member, you must ensure that the transaction complies with IRS guidelines and criteria. Foremost among them: 

  • Rental rates for the property must align with fair market values appropriate to the location.  
  • You must write out a formal written rental agreement. 
  • You must diligently enforce the terms of the rental agreement, particularly as it pertains to the punctual payment of rent. 

If you establish and adhere to these guidelines, you can rent a 1031 exchange property to a family member. Let’s break it down a bit further. 

Fair Market Rent 

The importance of fair market rent can best be explained using the 2013 tax court case Adams v. Commissioner (TC Memo 2013-7) as an example. In the mentioned case, taxpayer Adams exchanged into a replacement property and rented to his son and family below fair market rent. The courts challenged this exchange, claiming that the intent was not for business or investment but rather for personal use as a family home. 

As retaliation, Adams alleged that the property was in poor condition, and to make up for renting below fair market value, his son made repairs on the property. Having experience as a contractor, the taxpayer made considerable repairs and paid for the materials out-of-pocket. His son lived on the property for four years, and in that time, maintained and continued making repairs as needed. 

In the end, the courts deemed this arrangement to equal fair market rent and the property eligible for tax deferment. 

Written Rental Agreement 

A rental agreement is essential for all landlords, even when you’re renting to a family member. It’s a binding agreement between landlord and tenant that defines the responsibilities of each party. Rental agreements generally list the policies, rules, and procedures for any disputes while living on the rental property, as well as rental rates and payment terms. 

For a 1031 exchange, a written rental agreement solidifies that the relationship is between a landlord and a tenant, and familial relation doesn’t change that relationship. 

Reporting Rental Income 

You must report all paid rent as rental income on your income tax returns. You must also take depreciation deductions on that return. The IRS states that rental income includes amounts paid to cancel a lease, advance rent, all expenses paid by the tenant, and security deposits not returned to the tenant. Rental expenses to deduct from total rental income include depreciation, repair costs, and operating expenses. 

Closing Thoughts 

If you are renting a 1031 exchange replacement property to a relative, it’s important to know that the IRS will closely scrutinize your exchange – the IRS wants to prevent free or reduced rent for relatives, which goes against the intention of holding the property for investment or business purposes. 

Before renting your exchange property to a relative or close family member, be sure to familiarize yourself with the basic rules of 1031 exchanges. Make sure your relative pays fair market rent, and demonstrate that you have a professional tenant-landlord relationship by working up a rental agreement that’s signed by both parties. 

Lastly, if you’re considering renting your 1031 exchange replacement property to a relative, make sure you go over every detail of the arrangement with your qualified intermediary

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.

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