Here’s a GREAT question from a client:
Bill,
We’re going to buy an investment property [out of state] for our son to rent from us. Considering actually buying two units. We are going to sell the home town condo in the near future but not before buying the [out of state] property.
Wondering about tax implications. We expect to net about $100k on the condo. If we sell it in 2 months but if we close on the [out of state] unit before closing on the home town unit would that count toward a 1031 exchange…can it be retroactive?
Thanks for reaching out with these great questions! Since this is such a common scenario for real estate investors, I thought it would be helpful to break it down clearly. If you’re planning to buy a rental property for your son, or any other related person, especially as part of a 1031 exchange strategy, here’s what you need to know:
🏡 Can You Use a 1031 Exchange If You Buy First?
No — 1031 exchanges are not retroactive.
- If you sell the home town condo after closing on the out-of-state property, you can’t apply the 1031 exchange rules.
- However, you can structure it as a reverse 1031 exchange — but that’s more complex and restrictive (more on that below).
📈 Capital Gains and Depreciation Recapture – What to Expect
If you sell the home town condo outright:
✅ Your total gain = Sales Price – Depreciation – Costs of Sale
✅ The gain breaks down into two parts:
- Depreciation Recapture – Taxed at a flat 25%
- Capital Gain – Taxed at 15% or 20%, depending on your AGI and capital gains tax rate.
✅ Net Investment Income Tax (NIIT): If your AGI is over the threshold ($250K married, $200k single), you’ll owe an extra 3.8% on the full gain.
✅ State Tax: Add the approprate rate for your state income tax.
👉 Example for North Carolina – If you sell the condo for around $238,000 and back out about 6% selling costs, have a remaining basis of $93k and total depreciation allowed or allowable* of $25k, you could be looking at roughly a $28K–$33K tax bill. That’s a BIG hit on $100k-$130k of profit.
💰 What Happens to Suspended Losses?
If you have suspended losses on the rental you’re selling or exchanging (hint: look for Form 8582 on your federal tax return, at the bottom of Page 2 “unallowed losses” for the activity):
- If you sell outright → the losses are released and can offset the gain, UNLESS you’ve made an aggregation election under §469(c) of the Internal Revenue Code (there are different elections under §469(c) for real estate professionals and non-real estate professionals, but aggregation of properties ties up suspended losses until ALL aggregated properties are disposed of.)
- If you do a 1031 exchange → the losses remain suspended and attach to the new property.
👨👩👦 Renting to Your Son, or any other related person – Key Tax Rules
- To qualify as a legitimate rental property (and preserve 1031 eligibility), you MUST charge fair market rent.
- You can’t gift the rent or cover it on his behalf.
- This is closely scrutinized with related party transactions — but the Tax Court has ruled in favor of taxpayers when fair market rent is properly documented. (See Adams v. Commissioner, T.C. Memo 2013-7 (2013)).
🔄 Reverse 1031 Exchange – How It Works
If you buy the out-of-state property before selling the condo, you could still qualify for a 1031 exchange through a reverse exchange:
✔️ A Qualified Intermediary (QI) and an Exchange Accommodation Titleholder (EAT) must hold temporary title to the property.
✔️ You can’t take personal possession of the replacement property before selling the original one.
✔️ No recourse loans allowed — financing must be non-recourse or cash.
✔️ Must complete the sale within 180 days of the purchase.
🔎 Reverse exchanges are more complex and expensive — but they can work if the numbers make sense.
🏆 Next Step: Let’s Talk Strategy
If you have questions or would like to explore these and other real estate strategies further, let’s set up a quick consultation to go deeper into the numbers and your tax position. Head HERE to see if you qualify for our Tax and Wealth Strategy.