Renting 1031 Exchange Property to a Relative

A common question I get is whether you can rent an exchange property to a relative. Most typically the client wants to buy a replacement property that they can rent to their son or daughter. The answer is yes you can – provided that you strictly follow two basic rules: 1) the rent you charge has to be fair market value for that type of property, and 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).

By far, the most important of the two rules is the fair market value requirement, and a recent court case shows just how important this rule is. 

Mr. Adams did a 1031 exchange, selling a rental house and buying an old, dilapidated house in a distant city that his son lived in. His son and daughter-in-law worked an average of 60 hours per week over a three month period of time to make the house livable. They repaired mold damage, replaced broken doors, fixed holes in walls, repaired rotten subflooring, prepared the floors for new carpet installation, scrubbed and repaired surfaces for painting, painted the interior of the house, renovated the kitchen, re-plumbed the kitchen and laundry room for gas, replaced electrical fixtures and appliances and performed landscaping. They also exterminated rats and other pests. The son and daughter-in-law were not compensated for their work and they paid for the out-of-pocket costs and home improvements themselves. 

After three months of work, the house was livable and the son and his family moved in and started paying rent of $1,200 per month while continuing to maintain and improve the house. Because the IRS contended that similar houses in the neighborhood rented for a "few hundred dollars more" per month they disallowed Mr. Adams 1031 exchange (although they did acknowledge that while the tenants in the neighborhood paid slightly higher rent, they did not maintain or make home improvements on their homes). 

Section 1031 requires that both the old and new properties have to be held for investment or used in the production of income. If you use the property personally, or let a relative live in it for free or for reduced rent, you haven't held the property for investment or used it in the production of income, which is the basis for the IRS's disallowance of the exchange. 

Mr. Adams argued 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 by the son. The tax court sided with Mr. Adams and allowed the exchange. To read the case and reach the conclusion that it is acceptable to rent a property to a relative for a little less than the fair market value or that it's OK to give your relative a credit for maintenance is to completely miss the important lessons this case gives us. 

The first lesson is that if you rent your property to a relative the IRS will most likely audit the transaction with a microscope; had the facts in this case been the same except that the renter was not related to Mr. Adams, the value of the rent would never have become an issue. The second lesson is that while the rent that was paid by the son was substantial and within a few hundred dollars of fair market value, the impact to Mr. Adams was the potential disallowance of 100% of his exchange; meaning that there's no allowance for a "partial exchange" in this situation. 

The third lesson is that in a given area the homes are not exactly alike, and the amount of rent paid by other renters will fluctuate within a range depending upon on small differences in the properties. When the IRS audits the transaction a couple of years afterwards, they'll go back and try to reconstruct what similar rental rates were in the area, and of course it's not in their best interest to find that the rent that was paid by your relative fell within the range; they tend to compare the rent paid to what was paid by renters at the top of the range. In other words, a "close enough" approach may very well bite you. I suggest that you document rents paid on similar properties in the area at the time of the transaction. Get written documentation from several reputable third parties, and hang on to this documentation; if you assume that you'll get audited it's easier to gather the documentation at the time of the transaction rather than a couple of years down the road – and the court will be more impressed with your current documentation than they will be with the IRS's reconstructed comparisons. 

And probably the most important lesson I tell my clients is don't get sidetracked by the fact that the IRS lost this case. Just because Mr. Adams won doesn't open all the doors to you renting to a relative at a rent that is "pretty close" — at least to within a few hundred dollars — of fair market value rent. The real lesson here is that if the IRS sees a weakness in your case they will exploit it and you could easily end up paying many tens of thousands of dollars in legal fees to defend it. If you're like me, it's hard to understand how Mr. Adam's transaction was disallowed, let alone ended up in tax court, but that's the nature of renting to a relative.