Do I need a 1031 exchange in my situation?

Question

Hello!

I am very new in investing and am confused on whether I need to use a 1031 exchange here:

I currently own a condo that my mother lives in rent free. I don’t have a mortgage on it. I bought it for her in 2016 for 75k. I’m now planning to list it for $170k. We are purchasing a duplex (just went under contract for it), and she will live in one unit and the other has a long term tenant.

My plan was to use the condo heloc as the down payment for the duplex, and then sell the condo and the proceeds would pay off the heloc.

Now I’m wondering, is this allowed? Or am I going to be paying taxes on the money I’m using as the down payment, since it’s not technically going through a 1031x?

Lastly, when we sell the condo, can we keep the 75k + 4k renovation costs for ourselves, and then put any remaining money after the heloc is paid off into a 1031x to then invest in other properties?

Thank you for your help!!

Austin Cheatham · Answer

Few different things going on here.

The condo proceeds from the HELOC used as a down payment will not be taxed.

The tax will come into play when the condo is sold. You'll pay capital gains tax on the gain on the sale. The capital gains would be based on sale price less basis. Which sounds like a 95k gain.

And yes, when the condo is sold you could opt to do a partial 1031 exchange with those proceeds and keep some for yourself. So in theory you could take the 80k and then 1031 exchange the 15k into another property and defer part of the gain. But with you taking a majority of the proceeds you would be paying tax on a majority of the gain. However dependent upon taxable income you could get away with a pretty low tax bill due to favorable capital gains tax rates.

Be sure to work with a qualified intermediary and a tax professional to ensure you comply with all 1031 exchange regulations and to be sure you keep basis correct as all a 1031 does is defer your gain.

Happy to help run some numbers or do some basic analysis for you if you would like.

Basit Siddiqi · Answer

The issue you have is that it doesn't appear that you have an investment property if you are letting a family use it rent free.A 1031 exchange requires the property that you are selling to be an investment property.best of luck.

Gregory Wilson · Answer

Paul, I'd also like to mention that doing a 1031 for $75k of long term capital gain is pretty iffy. If you are taxed at 15% on LTCG that is all of $10k. A lot of baggage for a deferral of tax on $10k, worth what? $600 per year of deferral? And, if Demorats are elected the favorable treatment will probably go away because they hate favoritism for capital gains. So you might defer 15% tax to pay 40% in three years.

Dave Foster · Answer

@Paul Gamber, Your situation is a little gray as you're sensing and @Austin Cheatham laid out.  Simply letting your mother live in the property rent free would make it personal property.  Renting to your mother would make it an investment property and eligible for a 1031 exchange.

There is no statutory requirement for income production to make a property eligible for a 1031 exchange.  The argument you would try to make if you want to do a 1031 is that you were holding the property for appreciation.  But no income coupled with personal use (your mother) would make it doubtful that it would pass if you were audited.

If you have not filed your tax return for 2023 it might be worth looking at actually renting it to your mom for 2023.  Make it market rent and declare it.  Then if you want you can gift that back to her using annual gift limits.  That would give you a year income on that tax return.  And make your case for a 1031 exchange stronger.

Gregory Wilson · Answer

If he titles the house in mom's name by gift (no gift tax this year due to unified credit) , she has lived there for the right amount of time, can she exclude the gain entirely under Internal Revenue Code Sec. 121? ($250,000 exclusion).

The only problem being did mom really own it even though it was titled in his name? He held title as "trustee" for mom and she reports and excludes the gain?

Jackson Hanssen · Answer

I don't think you qualify for a 1031. owning a property your mother lives in doesn't seem to meet the held for investment test necessary.

Austin Cheatham · Answer

Also adding in here for anyone else viewing that we would need to consider the possibility of the IRS classifying this as a second home versus an investment property and disallowing any potential 1031 exchange due to allowing a family member to use the home rent-free.

There are safe harbors to qualify for a 1031 exchange. The safe harbor requires the Exchanger to have owned it for twenty-four months immediately before the exchange, and within each of those two 12-month periods the Exchanger must have 1) rented the unit at fair market rental for fourteen or more days, and 2) restricted personal use to the greater of fourteen days or ten percent of the number of days that it was rented at fair market rental within that 12-month period.

Gregory Wilson · Answer

You should have titled the property in mom's name, with a mortgage and an option to purchase it from her for the $75,000 at any time to protect you, if something happened to mom. Then when the property is sold, she excludes the entire gain as a sale of her personal residence ($250,000 exclusion) and she then gifts you the proceeds (nontaxable) saving all of the tax with no 1031 cost or deferred taxes.

Just sayin . . .

Do I need a 1031 exchange in my situation?

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