Can I defer capital gains tax on 1031 exchange for property rented to my daughter

By G. Scott Haislet, CPA, Esq.

Can I rent a 1031 exchange condo to my daughter?

Yes, you can. But I suspect that what you really want to know is whether or not you can defer recognizing any gain from the exchange itself on your income taxes. That depends on how your daughter is paying rent to you.

For you to not recognize gain on property involved in a 1031, or like-kind, exchange, you must ensure that the replacement property is being held for investment or will be used in a trade or business. Normally, a rental property is considered investment property. But if the investor’s child occupies the property, the law deems that the investor is personally using the property. The IRS therefore does not recognize it as investment property under 1031 rules. Thus the investor must recognize a gain on his income taxes.

But fortunately the law provides a way to get around this issue. If your daughter pays a market-rate rent (i.e., a rent equivalent to what a nonrelative might pay for occupying a similar property) and maintains an arms-length lease arrangement (i.e., a lease arrangement that you establish with a third party such as a property management firm), the property will qualify for 1031 treatment.

It also may be possible for you as a 1031 investor and your daughter and child as owner-occupant to establish an equity-sharing arrangement. That would allow you to invest your 1031 funds while helping your daughter get a toehold on the real estate market. It is even possible for both you and your daughter to co-sign mortgage financing for the equity-share property. If you do this, you need to be sure that you are fully complying with sections 1031 and 280A of the tax code so that you realize the benefits of a 1031 exchange.

Like-kind exchanges are complicated. So you might want to consult a CPA if you should want to do another 1031 exchange. You can find out more about like-kind exchanges by watching or listening to CalCPA's Financial Empowerment podcast on the subject.

G. Scott Haislet, CPA, Esq. is a tax adviser, estate planner and real estate attorney.