Investing in real property with a 1031 exchange can be a lucrative venture; however, an investor can also lose a considerable amount of potential income to capital gains taxes if the purchase and sale of properties is not conducted with care. One option for taxpayers who are trying to avoid paying the often high rate of capital gains taxes is to enter into a Section 1031 Exchange instead of a traditional sale. When a transaction qualifies for Section 1031 treatment, the profits realized as a result of the exchange are deferred for purposes of computing capital gains taxes. Although the general concept behind a Section 1031 Exchange is rather straightforward, an overlooked detail can cost a taxpayer as significant amount of money because a taxpayer who fails to meet each and every requirement for Section 1031 treatment will lose the tax benefits offered by a 1031 Exchange.
Section 1031 Exchange
A Section 1031 Exchange contemplates an exchange of like-kind property instead of an outright sale. In a traditional Section 1031 Exchange, a property owner who wishes to sell a property will locate a Qualified Intermediary to facilitate the exchange and then begin to search for a suitable replacement property. In a reverse exchange, the replacement property is identified first and then the original property sold. In either case, the entire transaction must generally be completed within 180 days. Another important requirement for Section 1031 Exchange treatment under the rules of the Internal Revenue Service, or IRS, is that the properties in question must be “held for productive use in a trade or business or for investment”. In some situations, it is readily apparent that the properties qualify as business or investment properties; however, there are other situations where the IRS may challenge this critical element of a 1031 Exchange. Among the factors that the court may look at when deciding the issue is whether the taxpayer charged “fair market rent” for the property in question.
Fair Market Rent Tax Court Case
The recent decision published by the Tax Court in Adams v. Commissioner, T.C. Memo 2013-7 (2013) is illustrative of the importance of charging fair market rent for a property for which a taxpayer is claiming Section 1031 treatment if the taxpayer is claiming the property was held as a rental property. In Adams, a taxpayer claimed Section 1031 Exchange treatment for the sale of a property and purchase of replacement property in California. The replacement property was in very poor condition upon purchase and required significant repairs in order to be habitable. The taxpayer admitted purchasing the property with the intention of renting it to his son and his son’s family. The son spent three months completing the repairs – for which he was not paid. Subsequently, the son and his family moved into the home and began paying $1,200 a month in rent for the next four years. Although the monthly rent was slightly lower than other similar properties in the area, the son also continued to maintain the property and conduct needed repairs during the time he lived there.
The Tax Court, looking at the taxpayer’s intent at the time of purchase, concluded that the taxpayer purchased the property as an investment and that he did not intend to charge less than fair market rent. The fact that he purchased the home with the intention of renting it to family members did not, in and of itself, rule out the possibility that it was also purchased as a valid rental property. Looking at the amount of work the son did on the home, and the continued responsibilities he had while living in the home, the court found that the amount of rent charged by the taxpayer was within the range of “fair market rent”. As such, the transaction was eligible for Section 1031 Exchange treatment.
Download the Ten Point 1031 Checklist when considering a Section 1031 Exchange by clicking here.
We Can Help
Atlas 1031 Exchange has been accommodating tax-deferred exchanges of all kinds for more than 17 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange.
Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.
