Renting to a Relative

Can I rent a 1031 Exchange Property to a Relative and still qualify?

The Tax Court has held that a taxpayer can rent a replacement property acquired in a 1031 exchange to a relative,  provided that they follow some key rules, including but not limited to: 1) the rent charged should be fair market value for the property and location and 2) the rental agreement should be in writing and the exchanger should enforce the terms of the agreement (most importantly the clause dealing with the late payment of rent).

In the case of William P. Adams v. Commissioner of Internal Revenue, T.C. Memo 2013-07, Mr. Adams transacted a 1031 exchange, selling a rental home and buying an old, dilapidated house in a distant city that his son lived in. His son and daughter in-law worked on the house over a three month period to make the home livable. They were not compensated for their work and paid for all of the home improvements out-of-pocket. Once the son and his family moved into the home, they paid $1,200 per month which the IRS claimed was less than homes in the neighborhood and disallowed Mr. Adams 1031 exchange.

Section 1031(a)(1) provides: “No gain or loss shall be recognized on the exchange of real property held for productive use in trade or business for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in trade or business or for investment.”

In general, using a 1031 replacement property personally, or allowing a relative to live there for free or with reduced rent that is far below the range of market rent would not be considered holding the property for investment or using it in the production of income, which was the basis for the IRS’s disallowance for the exchange.

In the end, Mr. Adams prevailed, arguing that the property was held for the production of income and that the rent was the fair market value rent considering the value of the substantial improvements made initially and continually by the son while he lived in the house.

All in all, if you want to hold an investment property that qualifies as either relinquished property or replacement property and you intend to allow a related party to occupy the property you should:

1. Collect fair market rent;

2. Have a written rental agreement;

3. Report the rents on your income tax return as rental income and take depreciation deductions on your return;

4.Preferably the related party lives in the property as their principal residence.

Legal 1031 Exchange Services, LLC does not provide tax or legal advice, nor can we make any representations or warranties regarding the tax consequences of your exchange transaction. Property owners must consult their tax and/or legal advisors for this information. Our role is limited to serving as qualified intermediary to facilitate your exchange. © 2021 Legal 1031 Exchange Services, LLC. All rights reserved.