Real estate that is owned, inherited, purchased, or sold, is quite possibly the largest single investment that an individual will own in their lifetime.  It is important to avoid any tax traps with the transfer of this asset.

Too often I hear from a client “I just sold the family farm and want to do a 1031 exchange now”.  I have to be the bearer of bad news and tell them there is a process that must be followed with an exchange and if you already sold your property, the timing of the exchange has already passed.  That window has already closed.  This detail is scrutinized by the IRS in 1031 exchanges.  There is a very specific process that must be followed to defer the tax in these situations.

In a nutshell, the exchange must be documented in the closing of the selling property, funds must be held in trust by a third-party intermediary, and specific time frames must be met to purchase the replacement properties.  If debt was held on the selling property, that debt must be taken on the replacement property.  The purchase price of the replacement property must be the same amount or greater than the sold property to enjoy the full benefits of an exchange.

If the replacement property will only be held short-term, the exchange may not make sense.  If the properties purchased and sold are personal residences then they do not qualify for an exchange, and the residential exclusion for the sale of a personal residence are potentially compromised.  Basically, a personal residence that is lived in for 2 or more years enjoys up to $500,000 in gain for married filing jointly.

Another issue that surfaces quite often is the transfer of real estate from grandparents or parents.  Too often I get the call stating “Grandpa’s mortality is coming to an end, so we put our name on all of his real estates before he passes”.  While there may be very limited circumstances to transfer real estate prior to death, there are many more problems that surface with that approach.

Individuals that inherit property upon the death of the grantor enjoy a step-up in basis to the fair market value at the date of death.  If the property was gifted in the lifetime of the grantor, the basis in the property remains the purchase price of the grantor.  For example, grandpa purchased the farm 60 years ago for $100 per acre.  Today the fair market value is $1,000 per acre.  If the property is transferred prior to death, the beneficiary has a basis in the property of $100 (grandpa’s purchase price).  If it is sold at current prices there is a capital gain of $900 ($1,000 – $100 = $900) that will be assessed if sold.  Alternatively, if the beneficiary waited to inherit the property upon the grantor’s death, they would receive the step-up on the basis of $1,000.  They could then sell the property for its fair market value of $1,000 and pay no capital gains tax.

The moral of the story, which cannot be emphasized enough, is call and ask your tax advisor prior to making any transactions that may have a significant impact on the taxability of your real estate.  Look before you leap, as our parents used to say.  Many other tax issues could be discussed, however, if you ask we can go over the tax consequences/benefits of your next real estate transaction.