Using a 1031 Exchange to Transfer Property to Kids

If you’re using a 1031 Exchange to transfer property to kids, you better plan ahead. The transfer to your kids could trigger a tax event and a large tax bill.

Q: I just watched one of your YouTube videos on your channel ExpertRealEstateTips on 1031 exchanges. We are a family of investors and have done quite a few 1031 exchanges. How do we facilitate the change of ownership on a property that was acquired through a 1031? My parents want to transfer the ownership of a few of their properties to me and my siblings.

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A: For starters, a 1031 exchange (also known as a tax deferred exchange) is a method used by an investor in real estate to sell one property and replace it with another. When the exchange is done properly, the owner ends up selling one, buying another property and not owing any federal income taxes, capital gains taxes or recapture of depreciation taxes on the sale.

1031s and Tax Deferred Exchanges

We’ve written extensively about 1031 exchanges to transfer property so we won’t go into the intricacies of an exchange here. The rules for 1031 exchange are governed by the Internal Revenue Code Section 1031 — hence the name, and you can find them here.

With a 1031 exchange, a long-time investor in real estate can buy, sell, and hold properties over time and never pay any federal income taxes, capital gains taxes or recapture taxes. It’s one of the best tax benefits for real estate investors.

In your situation, we can assume that as your family purchased properties over the years, they likely used tax deferred exchanges. The issue for your family is once your parents dispose of or sell those properties, the tax bill will come due when using a 1031 Exchange to transfer property to kids

If you’re asking how your parents can simply sell the properties to you, or transfer ownership to you and your siblings, that’s easy. They’d simply prepare documents of conveyance giving you and your siblings ownership of the properties. If their goal is to transfer the properties without paying taxes to the Internal Revenue Service, that’s more complicated.

We’re going to assume that your parents will have a hefty tax bill due when they sell the properties. If that’s the case, an estate planning attorney may suggest selling the properties to you and your siblings on an installment basis. In this way, your parents would avoid paying that tax bill all at once, and can plan to sell other investments that may offset the amount owed.

Ownership of real estate and 1031 exchanges

If you, your parents, and your siblings all hold an interest in a company that owns the real estate, the company could transfer ownership of the properties to your parents, you and your siblings. With that distribution, if it’s available to all of you, each of you would end up owning your share of each property in your own names.

That would at least get each of you your ownership interest. As far as your parents’ ownership interest in the properties, that sort of transfer might trigger a tax event. However, your parents probably have a tax specialist who has been advising them through the years, who can help them understand the financial consequences of transferring ownership of their properties to their kids now or over time.

Finally, it’s possible that your parents have already thought about their exit, and how it will play out. They may be planning to do a final 1031 exchange to transfer property, selling the properties to invest in something that will provide steady income but no longer require the work involved with owning and maintaining investment real estate.

Plan carefully and use an estate planning attorney

Talk with an estate planning attorney who also has experience with investment real estate properties. There are law firms that have this expertise, so try to find someone who comes highly recommended. (Talk to your local bar association and ask for the head of the local estate planning or real estate committees. They will typically know which local attorneys have the expertise you seek and can provide referrals.) Finally, if your parents have been working with competent help all these years, you may want to ask them to set up a family wealth planning session.