If you have substantial wealth tied up in assets, you’ll know that transferring this wealth is a serious concern. Not only do you have to think about the ramifications of gifting portions of your wealth and property during your lifetime, you must also be concerned about leaving your wealth to others posthumously as well.
Transferring property, both while living and after death, always brings up tax issues. Whenever an asset changes hands, no matter how much value it possesses, there is always the possibility that this transfer will trigger tax consequences.
Fortunately for investors, it is possible to gift exchange property. As long as certain conditions are met, you can use relinquished property that was previously gifted to you, and you can give a gift of replacement property acquired through a 1031 exchange. However, the important thing is making sure that you have the ability to prove that your property was held for investment or business purposes. If you dispose of your property before you have established that it was held for such purposes, you risk losing 1031 eligibility.
Gifting Can Affect Your Intent to Hold Property for Qualified Use
Property exchanged under section 1031 must be held for investment or business purposes. Property that falls outside of this category, such as property used as a personal residence, cannot be used in a 1031 exchange. There are a number of ways that you can prove that your property satisfies this requirement.
If you’re an investor, you will want to show that you’ve been holding the property specifically for the purpose of realizing financial gain. You will want to show rental income or the fact that you have avoided living in the property as a personal residence. And you will want to highlight the amount of time that you’ve been doing this.
Contrary to what you may initially think, there is no set time requirement used to establish your intent. We do know, however, that what happens before the exchange and after the exchange is relevant. So if you live in your relinquished property immediately prior to the exchange, or you begin to live in your replacement property very soon after the exchange, this may bar 1031 treatment.
The key takeaway regarding gifting in the context of 1031 exchanges is that gifting can play a role in the establishment of your intent. Again, there are no fixed deadlines as far as when the property may be gifted. The critical determinant is whether the intent requirement has been established for legal purposes. If you received a piece of real property as a gift in the distant past—say 10 years ago—and you have subsequently held it consistently as an investment property, then you should encounter no problems establishing intent when you use this piece of real estate as your relinquished property in a 1031 exchange.
As we’ve seen before, things are relatively simple when we deal with extreme examples. The difficulty arises when taxpayers test the bounds of what constitutes intent. Let’s use a real-world example to get a better sense of how gifting can impact the showing of intent.
Understanding Gifting Using Click v. Commissioner as a Real World Example
The case of Click v. Commissioner (1982) provides a good example of how a gifting can render a 1031 exchange invalid after the exchange has already been completed. In the Click case, the taxpayer, Dollie Click, received two residential homes as replacement property in a 1031 exchange. The relinquished property was a piece of farmland that was given to the other party, Marriott Corporation.
Shortly after the exchange, Click allowed her children to live in the two homes rent-free. The children lived in the homes rent-free for seven months, and then after this seven-month period, Click formally gifted the properties to the children. The tax court determined that Click’s behavior indicated that she did not intend to use the replacement property for investment or business purposes, but she instead intended to use it as a principal residence for her children. The court viewed Click’s actions before and after the transaction in making its decision. Before the exchange took place, the court found evidence that Click was looking for a home for her children. The court used this evidence to support its finding that there was no intent to use the replacement property for a qualified purpose.
Gifting is a perfect example of a phenomenon that is tricky because of its lack of bright line rules. As mentioned, gifting is not subject to particular time requirements, and it’s not entirely clear how gifting can undermine investment intent in any given situation. Everything depends on the specific facts of each case.
If you’re contemplating making a gift of your replacement property at some point in the future, the best thing to do is seek out guidance. At CWS Capital Partners, our experienced team is intimately familiar with this 1031 exchange issue, and we would be happy to share our expertise.
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