For investors planning to sell a rental property, a 1031 exchange offers the opportunity to defer capital gains taxes and depreciation recapture by reinvesting the funds into one or more new replacement properties. However, to complete this transaction successfully, it’s critical to carefully follow all of the rules and deadlines set forth by the Internal Revenue Service (IRS) and explained in section 1031 of the Internal Revenue Code.
Occasionally, we speak to investors who want to know whether they can change ownership of a property shortly before or after a 1031 exchange. While this may be acceptable in some cases, there are circumstances that could cause the exchange to be disqualified – potentially leaving you with a big tax bill. Here’s a look at some of the important factors to consider.
To qualify for a 1031 exchange, both the relinquished property and the replacement property must be “held for business, investment, or productive use in a trade.” While you may have a legitimate reason for wanting to change property ownership, if it’s done too soon, the IRS may determine that you did not intend to hold the property for business or investment purposes. If the IRS believes you engaged in a 1031 exchange for the purpose of tax avoidance. it may be disqualified.
Under IRS rules, to successfully complete a 1031 exchange, the same taxpayer who sold the relinquished property must purchase the replacement property. In addition, the title must match exactly. For example, if you held the first property in the name of your LLC, you cannot purchase the second one under your personal name or add your spouse to the title.
If your lender requires you to add your spouse to the title, be sure to document the request so you can prove that the change was required and was made for financing reasons, rather than to avoid tax liability.
There are no written rules that state a minimum holding period for relinquished properties. However, the IRS has issued safe harbor guidelines that define a “qualifying use” period. The guidelines state that investors must hold a property for at least two years before engaging in a 1031 exchange.
The holding period for replacement properties is also not specifically defined. However, experts typically recommend holding a property for at least one to two years before changing ownership.
Changing the ownership of a property involved in a 1031 exchange can create some significant complexities. Depending on the timing of the change, you may run the risk of having the entire exchange disqualified.
If you must make a change before the one-to-two-year recommended holding period, it’s important to consult with tax, legal, and financial professionals and engage a qualified intermediary (QI) to facilitate your transaction. To learn more about 1031 exchanges and whether this type of transaction may help you reach your financial goals, contact our team for a consultation.