Gifted Property 1031 Exchange: The Basics
If you receive a property as a gift, you can still conduct a 1031 exchange with it, so long as it’s a qualifying property type and you held the property for qualified purposes – either for investment purposes or if it was used in your trade or business. If those conditions are met, you can sell the property in a 1031 exchange, replace it with a property or group of properties of equal or greater or value, and pay no capital gains taxes.
Do I Need to Wait Before Gifting the 1031 Property?
In order to qualify for a 1031 exchange, you must prove that you held it for investment purposes or for use with your trade or business. Properties held for personal use (like for your primary home) or as inventory or stock in trade (essentially, being held for sale) are not eligible for a 1031 exchange.
While you don’t have to wait any particular minimum time period after the first 1031 exchange before trading your property in another exchange, you do need to prove your intent. An easy way to prove your intent with the property is to hold it for a substantial period of time. To further strengthen your proof of intent, you can use the property in ways that are consistent with typical business or investment uses, like renting it out for market rate lease, conducting business at the property, and so forth.
If you are ever audited by the IRS, you can prove your intent much more easily if you have at least a few years’ worth of tax returns for the property that show it was used to generate rental income or had depreciation or other business expenses. Otherwise, you risk triggering a “dealer status” with the IRS which can land you in trouble.
Don't Fall Into This Trap
Many people will fall into the trap of thinking that as soon as their 1031 exchange is complete, they can do whatever they want with the new property, including gifting it. However, this is not the case, because you still have to prove the proper intent of investment or business usage with your new property before doing anything else with it, or else you risk ending up in hot water with the IRS.
If you gift the property immediately after the exchange, it will be clear to the IRS that you actually did not have proper intent to use the property for investment or business. Your main desire at the time of the exchange must be to use your like-kind replacement property only for business or investment. If you eventually want to gift your property after properly using it for several years, it’s best to consult with your accountant and tax advisor to determine if you are allowed to do so.
A 1031 Property Gifting Example
Dollie Click is an individual who fell into this trap. In the 1982 United States Tax Court case Click v. Commissioner, Dollie was found to have disqualified her recent 1031 exchange by gifting the properties she received to her children. She exchanged a farm that she held for investment purposes for two single-family home properties as well as some taxable boot. Once the exchange was completed, she let her children move into the homes and live there for seven months without paying rent. The children took out property insurance, paid property taxes, and even made and paid for repairs and various improvements to the homes.
After they had lived there rent-free for seven months, Dollie officially gifted the properties to her children, which led the U.S. Tax Court to decide that she did not qualify for her recent 1031 exchange because she did not intend to hold the properties for business or investment uses. Her activities with the replacement properties were found to be highly indicative of her intent to gift the homes to her children, although she claimed to the court that her children were serving as ‘caretakers’ during the period between the exchange and the gifting.
However, the circumstances matter. In some cases where owners have gifted or even moved into their replacement properties soon after a 1031 exchange, the court has found that at the time of the exchange, the property owner’s intent was to hold the properties for appropriate purposes.
If you’d like to learn more about 1031 exchanges, contact us at TFS Properties today. We can walk you through the process, help you find a qualified intermediary, and guide you in your search for replacement properties or portfolios.