Case:

Karl Hendricks was a man with the golden touch. Throughout his life, it seemed every investment idea that he touched turned to gold. By far, Karl was most successful with real estate investments. It was definitely his passion.

Amazingly, Karl continued to buy and sell real estate at the age of 85. His most favored tax strategy for buying and selling real estate revolved around I.R.C. Section 1031. In short, Section 1031 allows taxpayers to exchange "like-kind" investment property without the recognition of gain or loss. This tax code provision does not exclude the recognition of gross income indefinitely but merely defers the recognition to a later date.

Karl currently owns a $2 million building that has significant appreciation. He acquired the building pursuant to a Section 1031 exchange. In fact, this building is his fifth Section 1031 building. Like many real estate investors, Karl just kept "trading up" over the years. As a result, Karl's basis in his $2 million building is extremely low.

Karl decided he wanted to sell the building, but he did not want to pay the "ticking tax time bomb." In addition, he did not want do another 1031 exchange because he was ready to retire from the real estate investment business.

Around this time, Karl learned of the benefits of a FLIP CRUT, e.g. income tax deduction, bypass of capital gain and future income stream. He especially liked the fact the FLIP CRUT could simply invest in stocks and bonds, which was something a 1031 exchange would not allow. Thus, after Karl learned about the benefits of a FLIP CRUT, he eagerly wanted to move forward.

Question:

It looked like the perfect solution. However, Karl did have one concern. Specifically, he acquired his building via a 1031 exchange from his son just nine months ago. Accordingly, Karl wonders if there is any required holding period before he may dispose of his 1031 property into a FLIP CRUT?

Solution:

When determining whether a holding period applies to property acquired in a 1031 exchange, the relationship of the parties is important. If the parties are unrelated, then there is no specific holding period. (See Part 15 of this series for a full discussion and exceptions to this general rule.) If the parties are related, then the tax code does impose a holding period upon the related parties.

Specifically, Section 1031(f) deals with related party transactions. In an effort to avoid basis "shifting" between family members, Section 1031(f) requires a two-year holding period after a 1031 exchange between related parties. If either the taxpayer or the related party disposes of the exchanged property within two years, then the taxpayer's exchange with the related party becomes taxable. Obviously, this is a very bad result.

In this instance, Karl acquired the 1031 property from his son, a related party. Since then, he has held the exchanged property for only nine months. Thus, he is 15 months short of the two-year holding requirement. Any disposition — by sale or gift — before the two-year period will trigger Karl's deferred gain. There are three key exceptions to this rule under 1031(f)(2). Unfortunately, those exceptions do not seem to apply to dispositions by gift, i.e. the CRT.

Karl desperately wants to avoid the capital gains tax on his building, and he is very excited about the FLIP CRUT benefits. Therefore, Karl decides to hold onto the property for another 15 months. Once Karl has met the required two-year holding period, he can move positively forward with his charitable and income tax planning goals.