The Internal Revenue Code Section 1021–”Exchange of Real Property Held for Productive Use or Investment–can be a way for you to possibly defer capital gains taxes and depreciation recapture on investment property you sell or use for business purposes.
When analyzing the concept of “investment,” one question arises: Can you rent a designated 1031 exchange property to friends or family?
The answer is yes, but only under certain conditions. Considering the above-mentioned lease activities, be aware of the various requirements involved. Failure to do so could jeopardize any potential tax deferral benefits.
Through a 1031 exchange, you could use the proceeds from the sale of investment or business real estate to acquire like-kind investment or business real estate. The properties involved can’t be used as personal residences.
However, you might decide to rent the property to yourself and pay rent to an LLC you formed to hold the property. Be aware that self-renting raises IRS scrutiny and could disqualify the exchange. Or a close friend or family member might approach you to ask if they can rent the building.
It’s possible to enter into such rental agreements with related parties as long as you follow these rules:
Market rates. While you might want to cut yourself, friends, or relatives a deal, resist the temptation. To ensure the property is within 1031 exchange rules, the rent charged must be comparable to fair-market rents in your area.
In-writing lease agreements. While you might trust yourself or related parties to pay rent, a handshake agreement won’t cut it when it comes to leasing 1031 exchange space. A lease agreement outlining the length of time and required payments must be filled in and signed by both parties. Failure to do so could raise a red flag with the IRS.
Holding period. As a reminder, properties considered for a 1031 exchange must be held for investment or business purposes. The difficulty is that the IRS doesn’t suggest a specific ownership timeline. However, it’s assumed that the longer you own the property, the more likely you’re holding it for investment purposes. The general rule of thumb is a two-year holding period.
Personal use. If your investment property is a vacation home you rent to related parties, you could use that property for your personal use as long as you:
Your 1031 exchange property is typically rented out to help generate cash flow. You can rent that real estate to yourself or a related party as long as you know the rules and limitations of doing so. Working with a tax professional and your Qualified Intermediary (QI) can help you follow the guidelines and support tax-advantaged strategies.
For additional assistance in finding a viable 1031 exchange property, contact the experts at Realized 1031. The staff offers years of experience in helping execute like-kind exchanges and is ready to help you navigate the rules and guidelines.
Visit realized1031.com to learn more or to set up a no-obligation portfolio analysis.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.