Every property investor wants to minimize the taxes they owe in the financial year when they sell their property. This way, they’ll have enough money to invest in another property.
There are different legal provisions that reduce the taxes owed on property investment, but the 1031 exchange is the most common. This allows you to defer the taxes on the profits you make from your property’s sale. The 1031 exchange encompasses different rules for the sale and replacement of your property for you to gain from tax deferral.
People assume that 1031 exchange companies in Nevada are unnecessary when getting involved in a 1031 exchange, but that’s not the case. The rules for them seem straightforward, although they — unfortunately — are not. One of the laws that have marred many 1031 exchange transactions is the related party rule, which addresses different aspects of a 1031 transaction between related parties.
The following are some guidelines to give you an insight into this often misunderstood rule.
Definition of “Related Parties”
The term “related person” seems straightforward, but it is a bit complicated in 1031 exchanges. The IRC considers related parties as half and full siblings, spouses, and direct lineal descendants. Fiduciaries, beneficiaries, and grantors of common trusts and corporate entities with at least 50% of its stock owned by one family member are also considered related parties in 1031 exchanges.
The Two-Year Rule
For a property transaction between related parties to benefit from tax deferral, the property you sell to or get from a related party should not be disposed of within two years of its purchase. This means if the related party you sell your property to disposes of it within two years of a transaction, you will not benefit from tax deferral. The same applies if you buy a replacement property from a related party.
Exemptions to the Two-Year Rule
You will be exempted from the two-year rule if either party in the transaction dies after the property’s transfer or if the disposition is not meant for tax gains. Proving that a property’s disposal is not intended for tax gains is generally subjective and hence tricky. A disposition with recognized taxes or one in which the taxpayer holds a greater or complete property interest might, however, be exempted.
The Underlying Structure of Your Transaction
If you have structured your transaction for the specific purpose of avoiding the taxation of your gains, then the 1031 exchange will be denied even if you comply with the other rules of the transaction.
A couple, for instance, might divorce about a month before the transfer of their property to a now ex-spouse. The couple then remarries after the property’s transfer, but have avoided the two-year rule for the transaction. They can, therefore, use the gains on their property to refurbish and resell the property within two years without paying taxes. This will be considered an incorrect underlying transaction structure and not benefit from tax deferral.
Taxpayers will generally use all tricks to avoid taxation. The 1031-related parties exchange rules are meant to minimize the risk of abuse of this privilege by taxpayers. Get a 1031 exchange expert to guide you in your exchange to guarantee you get your taxes deferred.