1031 Exchange: IRS Rules For Investment Property Purchase

Added February 13, 2004 by Ilyce R. Glink and Samuel J. Tamkin

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Summary: A father wonders if he can do a 1031 exchange and rent back the newly purchased investment property to his struggling son. Sam discusses the details of the 1031 exchange commonly known as Starker trusts, the IRS rules behind them and how they apply to investment property. One key point: a good real estate attorney will help you navigate the IRS tax rules about a 1031 exchange and how it applies to investment property.

Q: My son and his new wife are struggling to make the payments on the home they just bought. I'm trying to think of ways in which to help.

My wife and I intend to build a home in that area someday, so I was thinking one way to help is for me to sell a rental home I own in another state and buy their home from them. I would then rent their home back to them at the market rent. I'd use a 1031 tax-free exchange to avoid paying any taxes.

At some point in time, we would plan to move into the rental house as our primary residence for at least two years while we build a retirement home.

I have two questions. At that point in time, could I then sell the house back to my son after we move out without violating any IRS rules? May I have my son and his family stay with us (rent free) during the time I take possession of the house and until I have our retirement home built? I anticipate the designing and building of the retirement home will take at least two years.

A: A 1031 Exchange is named after the provision of the tax code relating to "like kind" exchanges. It refers to the sale of one investment property for the purchase of another, such as an apartment building for another apartment building, or a commercial building for an apartment building.

These exchanges are also commonly known as "Starker" trusts. The basic principle is that a seller of one property buys a second property for more money and defers any gain he would have realized on the sale of the first property.

The rules for a 1031 exchange can be complex and the timing requirements are strict. Typically, you'll hire a third-party intermediary to handle the exchange for you.

In your case, you may be able to sell one of your investment properties and buy your son's home. The purchase of the home must be for investment purposes and you may have to hold on to your son's home as an investment property for at least two years. In addition, there are specific IRS rules relating to transfers between related parties. You will need to make sure you understand the rules and can abide by them.

If your ultimate plan is to move into the home or you plan to sell the home back to your son, you may be violating some of the 1031 regulations. Of course, if you are able to convert the investment property back to a personal residence, you may have anyone you like live with you.

Consult with an attorney that specializes in 1031 exchanges or with a qualified intermediary for more information. You may also want to talk to your tax preparer to discuss the effect this plan will have on your taxes.

Feb. 13, 2004.

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