Question About 1031 Tax Exchange

[allanb]

State Of California: Mother-In-Law was a hoarder. Got her out of the house and into assisted living about 5 years ago. It has taken 5 years for the trustee, my Brother-In-Law, to renovate the property, it was a disaster but he has also been negligent in his duties. The house is 90% finished and has not been rented out yet. Seeing as it has not been rented out at all does it still qualify for a 1031 tax exchange?

 

[LdiJ]

State Of California: Mother-In-Law was a hoarder. Got her out of the house and into assisted living about 5 years ago. It has taken 5 years for the trustee, my Brother-In-Law, to renovate the property, it was a disaster but he has also been negligent in his duties. The house is 90% finished and has not been rented out yet. Seeing as it has not been rented out at all does it still qualify for a 1031 tax exchange?

A 1031 exchange has to do with selling a property, not renting one out. At any time a property could be sold through a 1031 exchange. However, it is complicated and the rules must be followed to a T. Those rules include using a third party to handle all of the aspects of the sale and exchange. Neither the beneficiaries nor the trustee would be allowed to handle it. It must be a professional third party.

Was your intent to trade this property for another investment property? Or did you misunderstand the meaning of a 1031 exchange?

 

[Taxing Matters]

State Of California: Mother-In-Law was a hoarder. Got her out of the house and into assisted living about 5 years ago. It has taken 5 years for the trustee, my Brother-In-Law, to renovate the property, it was a disaster but he has also been negligent in his duties. The house is 90% finished and has not been rented out yet. Seeing as it has not been rented out at all does it still qualify for a 1031 tax exchange?

A section 1031 exchange has to be one commercial/investment property for another. As it's never been rented or offered for rent and was her personal residence, it won't qualify for the § 1031 exchange at this point in time. With a little more time and effort, though, they could get it to qualify as rental/investment property.

There might be a better option. While the facts you provided would suggest that the gain exclusion for sale of personal residence is not available here, I can't totally rule it out without exact dates. Take a look at Publication 523, page 3 that discusses the residence test. If she's still qualified, the best thing to do is probably just sell it and take the gain exclusion she's eligible for and then reinvest the money in whatever way makes the most sense for her. Buying another piece of real estate may not be the best investment for her given her condition. But whatever the new investment is, she'll get cost basis in it. The way the home real estate market is today in many places, putting the money into another property at this point might not be the wisest investment.

How much gain is there here? Remember, the cost of material and hired labor that the trustee put into the property would add to basis. Fixing up a home of a severe hoarder is often quite costly. It may be, depending on all the facts that go into basis, that there isn't a huge amount of gain to worry about anyway. So figure out that now, because that gain figure will play a significant part in the planning. Look at the total financial picture here before deciding. If the money would pull a bigger return in an investment other than investment/rental real estate, it may well be better to sell it and take the tax hit now rather than trying to do a § 1031

 

[allanb]

A 1031 exchange has to do with selling a property, not renting one out. At any time a property could be sold through a 1031 exchange. However, it is complicated and the rules must be followed to a T. Those rules include using a third party to handle all of the aspects of the sale and exchange. Neither the beneficiaries nor the trustee would be allowed to handle it. It must be a professional third party.

Was your intent to trade this property for another investment property? Or did you misunderstand the meaning of a 1031 exchange?

The intent was to sell the subject property and buy another of equal value for rental purposes. However, the info that I had was that the subject property must have been rented out for at least 2 weeks or it wouldn't qualify for a 1031 tax exchange. As it had NOT been rented out for 2 weeks. What I was trying to clarify was, as my Mother-In-Law had been in an assisted living facility for about 5 years, and during that time the property had been going through renovations. I was wondering if this was an exception to the 2-week rule. Technically as she lives in an assisted living home, then the subject property could be a rental (investment property) except for the fact as of this date it has just sat there unrented. I suppose I could have her rent it to myself for 2 weeks and go live in it for 2 weeks and then that would take care of the rental requirement.

 

[allanb]

A section 1031 exchange has to be one commercial/investment property for another. As it's never been rented or offered for rent and was her personal residence, it won't qualify for the § 1031 exchange at this point in time. With a little more time and effort, though, they could get it to qualify as rental/investment property.

There might be a better option. While the facts you provided would suggest that the gain exclusion for sale of personal residence is not available here, I can't totally rule it out without exact dates. Take a look at Publication 523, page 3 that discusses the residence test. If she's still qualified, the best thing to do is probably just sell it and take the gain exclusion she's eligible for and then reinvest the money in whatever way makes the most sense for her. Buying another piece of real estate may not be the best investment for her given her condition. But whatever the new investment is, she'll get cost basis in it. The way the home real estate market is today in many places, putting the money into another property at this point might not be the wisest investment.

How much gain is there here? Remember, the cost of material and hired labor that the trustee put into the property would add to basis. Fixing up a home of a severe hoarder is often quite costly. It may be, depending on all the facts that go into basis, that there isn't a huge amount of gain to worry about anyway. So figure out that now, because that gain figure will play a significant part in the planning. Look at the total financial picture here before deciding. If the money would pull a bigger return in an investment other than investment/rental real estate, it may well be better to sell it and take the tax hit now rather than trying to do a § 1031

Well, page 3 of Publication 523 is referencing, I believe the capital gains exclusion of the sale of your home that you have lived in for the past 2 out of 5 years. For my Mother-in-Law that would be a $250k exclusion, the problem is that I failed to mention is the home has a basis of about $50k plus about $100k for renovations and is worth about $1.3 million. She would get clobbered in that situation. and doesn't have the cash. However, she is 93 years old so the thought was, as the property is still not ready to be rented and my wife and the Trustee are tired of the process of getting it renovated, then sell it as an investment property at a slight discount to someone that wants to finish the job and use the 1031 to purchase a like property that is turnkey and ready to rent. The only missing piece of the puzzle is that it has not been rented out yet for 2 weeks. That is what I am trying to determine if her situation allows an exclusion in this stated situation. I do realize that I need a third party to handle the 1031 tax exchange. Another reason for this is in the state of Californi if you are her age you can transfer the County tax base of the subject property to the next property in the upleg of the 1031 exchange....plus as she will pass away eventually the property will be reasessed at the current market value of the date of her death, be sold at that price and eleiminate any Capital Gains Tax for the Benificiaries. I think it probably would be best to call an IRS Agent and clarification from them. I just thought someone on the forum may have run across this situation in the past as I always have to wait for a very long time to talk to an IRS Agent.

 

[LdiJ]

Well, page 3 of Publication 523 is referencing, I believe the capital gains exclusion of the sale of your home that you have lived in for the past 2 out of 5 years. For my Mother-in-Law that would be a $250k exclusion, the problem is that I failed to mention is the home has a basis of about $50k plus about $100k for renovations and is worth about $1.3 million. She would get clobbered in that situation. and doesn't have the cash. However, she is 93 years old so the thought was, as the property is still not ready to be rented and my wife and the Trustee are tired of the process of getting it renovated, then sell it as an investment property at a slight discount to someone that wants to finish the job and use the 1031 to purchase a like property that is turnkey and ready to rent. The only missing piece of the puzzle is that it has not been rented out yet for 2 weeks. That is what I am trying to determine if her situation allows an exclusion in this stated situation. I do realize that I need a third party to handle the 1031 tax exchange. Another reason for this is in the state of Californi if you are her age you can transfer the County tax base of the subject property to the next property in the upleg of the 1031 exchange....plus as she will pass away eventually the property will be reasessed at the current market value of the date of her death, be sold at that price and eleiminate any Capital Gains Tax for the Benificiaries. I think it probably would be best to call an IRS Agent and clarification from them. I just thought someone on the forum may have run across this situation in the past as I always have to wait for a very long time to talk to an IRS Agent.

You would be better off talking to a tax attorney rather than an IRS agent. You would be more likely to receive an accurate response from a tax attorney.

It would seem to me that it would be less complicated to simply finish the renovations and rent out the property rather than trying to do a 1031 exchange.

 

[Taxing Matters]

I think it probably would be best to call an IRS Agent and clarification from them. I just thought someone on the forum may have run across this situation in the past as I always have to wait for a very long time to talk to an IRS Agent.

The problem is that when you call the taxpayer service numbers for the IRS, you are not speaking to an IRS agent (which is a person who has extensive knowledge of accounting and tax and conducts audits of large businesses/wealthy individuals on site) or a tax examiner (who is has less detailed knowledge of some parts of the code than an agent does, and conducts audits of return at his/her IRS office). You are talking to taxpayer reps who have training in tax mostly focused on individual taxation. The rep you get may not know all the details of what is needed to do a § 1031 exchange successfully. Screw it up and you may be hit with a penalty and/or loss of the tax free exchange. Oral advice given to taxpayers by IRS personnel is not a defense to that. Only written advice from the IRS counts, and that explanation generally comes from IRS counsel and you have to pay a considerable fee for it.

I suggest talking with someone (accountant, attorney, enrolled agent) who has handled a number of § 1031 exchanges to see if you'd qualify for it and whether that's the best thing to do. Bear in mind that if you do it, you'll lose any of the gain exclusion for sale of a personal residence. If she's going to own it until she dies that's not a big deal because she'll get the basis step up then. But if for some reason she needs to sell it while still alive that could result in more tax being paid.

 

[allanb]

Thank you for all your responses!! I really appreciate it, it was all good advice!