I am selling an apartment building in which I am realizing a $2,000,000 capital gain. I would like to buy a home for my niece that will cost $500,000. Is there a way that I can defer some taxes with a 1031 exchange?
It sounds like a 1031 exchange might not be the right option for you. As I wrote in “Where Does Cost Basis Go in a Partial 1031 Exchange,” the cost basis from the property you give up rolls over into the new property.
The house you want to buy for your niece will receive the basis you had in the apartment building. If that basis is more than the value of the house at $500,000 (which it could easily be given that you’re facing a $2 million gain on the sale), none of the gains you realize will be deferred. If there were multiple properties you want to purchase, you might be able to roll the gains into some of those properties as well, but every additional property involved makes the process much more complicated.
Second, 1031 exchanges are a tool for the acquisition of investment property, not personal property. So if you want to buy a house for your niece immediately, a 1031 exchange won’t help. But as I wrote in “When Can I Move Into a 1031 Property,” there are ways around this.
You can acquire what will ultimately be a residential property through a 1031 exchange, but when you acquire it, you have to use it as an investment for two years. The IRS will look at whether it was rented at “fair rental value” during that time, it must have been rented for at least two weeks each year, and you must not use the property personally for more than 10% of the time it was rented.
A 1031 exchange affects the cost basis in your house which can be important if you plan to occupy it as a residence and have to sell it later. It will have the same basis as the property you gave up. In traditional 1031 exchanges, that means the cost basis will be low since the whole reason to do a 1031 exchange is to avoid recognizing a large amount of capital gains which come from a large difference between the property’s current value and its cost basis. You probably won’t have that problem as you’re proposing downsizing significantly and not deferring all the gains on the apartment building will be a bigger problem than how many gains will be realized if you sell the house in the future.
Using a 1031 exchange to turn investment property into residential property is possible, but it takes careful planning from the outset. If that’s what you’re trying to do, I’d read the article I mentioned earlier, “When Can I Move Into a 1031 Property.”
If you’re set on selling the apartment building and are trying to use a 1031 exchange as a reactive strategy to manage the gains coming your way, there may be too much time pressure to make it work.
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