Renting a 1031 Exchange Property to a Relative
You may rent your exchange property to a relative provided that you strictly follow three basic rules: 1) the rent you charge has to be fair market value for that property, 2) your rental agreement must be in writing and you must enforce the terms of the agreement (most importantly the clause dealing with the late payment of rent), and 3) the relative should use the property as his/her primary residence.
In the case of William P. Adams v. Commissioner of Internal Revenue, Mr. Adams did 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 property held for productive use in trade or business for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in trade or business or for investment.”
Using a property personally, or allowing a relative to live there free or with reduced rent is not holding the property for investment or using it in the production of income, which is the basis for the IRS’s disallowance for the exchange.
In the end, Mr. Adams won the case, arguing that the property was held for the production of income and that the rent was the fair market value rent when you factor in 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