Vesting and 1031 exchanges require attention to the same taxpayer rule, which can be tricky if you don’t understand it. This article will hopefully clarify the potential and the topic for those interested in exchanges.
To qualify for tax deferral treatment under Internal Revenue Code § 1031, the taxpayer who is the seller of the relinquished property must also purchase the replacement property. For example, if Alex Smith, as an individual, sells his relinquished property, Alex Smith, as an individual, must also buy the replacement property. This sounds simple enough, but often investors overlook this important detail, which is essential in regards to vesting and 1031 exchanges.
Same Taxpayer General Rule
Investors should confirm how they own title to the relinquished property to comply with the general rule. Investors should plan to acquire the new replacement property using the same form of ownership. Limited exceptions are below in the “Disregarded Entities” section.
If title to relinquished is held by:
Real Estate Corp.
Title to replacement must be held by:
Real Estate Corp.
There is one exception to this general rule. Some entities are considered “disregarded entities” for tax purposes. Although it exists in the “real world,” a disregarded entity signifies that it is entirely ignored for tax purposes. For example, Paula sells her investment property. Paula can then purchase the replacement property in her name or the name of her revocable trust. She can do this because a revocable trust is a disregarded entity. Paula could also acquire the replacement property using a single-member limited liability company. As long as Paula is the sole LLC member (i.e., owner), the LLC is a disregarded entity, which means it is ignored for tax purposes. In each of these scenarios, Paula will be considered the “same taxpayer” as the revocable trust or single-member LLC.
Suppose Paula is married, and Paula and her husband own the relinquished property. In that case, they can buy the replacement property using either a revocable trust or LLC in which they are the only two owners. As long as they are the sole owners of the LLC and the property is community property, the LLC will be ignored for tax purposes.
Using a single-member limited liability company to acquire the title gives an investor more flexibility with their lender. Lenders often require that property pledged for a loan be held in an entity owning only that property. That way, the borrower’s other assets do not adversely affect the pledged property. Using a disregarded entity to do that will satisfy the lender while complying with the 1031 tax rules.
Investors should pay close attention when removing or adding a spouse to the title on the relinquished or replacement property. Adding a spouse to the replacement property title immediately after acquiring it may be treated as a one-half interest gift by the IRS. If this is the case, it will not satisfy the “held for investment” requirement. Removing a spouse from the title may also have tax consequences. Investors should discuss these potential issues with their tax advisors before selling the relinquished property.
Investors should pay special attention to vesting and 1031 exchanges regarding issues when holding title in a partnership. Section 1031 specifically excludes partnership interests. It is impossible to defer tax under IRC § 1031 by disposing of or acquiring a partnership interest. Moreover, because of the “same taxpayer” rule, if a partnership sells the relinquished property, it must buy the replacement property. Individual partners cannot separately exchange out of the property that is owned by a partnership. Although there are some potential solutions to this problem, they generally require planning and legal work.
For example, sometimes, the partnership that owns the relinquished property is dissolved. In this case, the property is deeded to the individual partners as tenants-in-common. Some individual partners then do an exchange with their portion of the property, and others cash out. There is some risk in this scenario. The IRS often assumes the partners have not held the relinquished property for sale purposes rather than an investment. Investors should seek a tax attorney’s advice when attempting to exchange out of a property owned by a partnership. In most cases, a limited liability company that has more than one owner is considered a partnership. The same tax issues will apply in this case.
Pay Close Attention
Finally, investors planning to do a 1031 exchange should pay attention to the vesting on the property they intend to sell. This attention ensures that the same taxpayer sells the relinquished property and purchases the replacement property. Advanced planning will go a long way towards having a smooth closing and a workable 1031 exchange.
If you have questions about the same taxpayer rule or want to learn more about vesting and 1031 exchanges, contact Midland 1031 for more information at 239-333-1031, or click here to schedule a free consultation.