Will a 1031 Exchange help avoid capital gains tax on an inherited home? When you inherit a home and use it as a rental property, you could face major tax implications when it comes time to sell unless you use a 1031 exchange.
Q: My mother who was very ill and on Social Security sold me her residence for $1.00 just in case something happened to her. We ended up moving her in with us until she died.
Her home was vacant and we decided to rent it out. But the time has come that we can no longer keep this up and need to sell it. We are worried about any capital gains taxes and want to take the money received from the sale to help pay down an existing home equity mortgage we have on our primary residence that also has attached rental units.
I’ve heard about a 1031 exchange. Could I apply it in this case?
Will a 1031 Exchange Help Avoid Capital Gains Tax on an Inherited Home?
A: A tax-deferred exchange (also referred to as a 1031 exchange or Starker exchange) is in its basic form the sale of an income-producing property with the purchase of a replacement income-producing property. While in the past, the IRS Code allowed exchanges of property other than real estate, that might change in the near future depending on what changes in the law are considered as a part of tax reform.
When it comes to real estate, you have to own a property that was held for investment purposes. To sell the property, you generally will use an exchange company to facilitate the sale and purchase of the replacement property. That company is usually an “intermediary exchange” company. You will still need your own attorney, settlement agent and title company to help out, but the exchange company will satisfy certain IRS requirements.
When you sell, all of the proceeds from the sale go to the exchange company. You then have no more than 45 days to find and notify the exchange company of the property you intend to buy as your replacement property and then you have no more than 180 days to close on that replacement property. And by the way, the replacement property sales price usually needs to be the same or higher than the sales price of the property you sold.
Those are the basics, but there are other intricate rules that you must follow to get the tax advantage you are seeking. If you qualify for a tax-deferred exchange, on the sale of the property, you get to defer the payment of all taxes on the sale of the old property, including any recapture of depreciation you might have and capital gains taxes.
Property Conditions and Purchase Considerations
We’re a bit concerned that the property was vacant for a while and we don’t know how you treated the property for income tax purposes when you purchased it. We also don’t know how your mom treated the “sale” of the home to you. Your question raises a number of issues from an income tax perspective from your mom’s side and your side as well. We’ll have to ignore those issues and talk about the 1031 issues instead. You’ll have to talk to your accountant, tax advisor or Enrolled Agent to get more information about the federal tax issues you might have.
However, if we can assume that you purchased the property for one dollar and your association with your mother doesn’t impair your ability to utilize a 1031 exchange, you essentially have all profit if you try to sell the property. If you kept the property as an investment for many years, treated the property as an investment, had every intent to use and keep the property for investment purposes, you might qualify and sell the property using a 1031 exchange. When you sell the property, you use the intermediary, buy a replacement property and defer the payment of taxes down the line. The replacement property must also be a property you intend to own for investment purposes.
If at any point in the course of reviewing the facts of your situation, you fail the test under Section 1031 of the IRS code, you won’t get the benefit of deferring taxes and the sale could give you substantial gain.
One last item: we don’t know if the “sale” of the property was intended as a true sale or whether your mom really gifted the home to you. If your mom gifted the home to you, your basis — or cost — in the home might be what your mom paid for the home. If what she paid for the home is about what the home is now worth, you might not have much tax to pay when you sell it.
Due to the complications and many facts that surround your situation, please talk to a tax advisor on your issue and also talk to a specialist in 1031 exchanges. Those specialists sometimes have a great eye towards seeing a transaction and telling you whether your situation fits the requirements of a 1031 exchange. They may also have a referral for you to talk to to help you with your tax situation. Good luck.