1031 Exchange Rules: Same Taxpayer Requirement
Buying and selling property with a 1031 exchange can be a very lucrative investment when done properly. Simply understanding the market, however, is not enough to ensure turning a profit. An investor must also understand the various tax consequences involved in real estate transactions. In the normal course of business, capital gains taxes are incurred whenever a taxpayer sells property and realizes a gain on the sale. One method that can be used to defer the payment of capital gains taxes is to enter into a Section 1031 Exchange instead of a traditional sale. In essence, a 1031 exchange involves the taxpayer relinquishing one property and acquiring a replacement property of “like-kind” within 180 days of the relinquishment. One of the rules of a 1031 exchange requires the same taxpayer to complete both ends of the exchange. While this may sound simple enough, there are some circumstances where the identity of the “taxpayer” for purposes of the exchange can become complicated.
Same Taxpayer Requirement
A straightforward exchange involving a single taxpayer on both ends of the transaction clearly meets the same taxpayer requirement; however, not all transactions are that straightforward. Spouses, business entities, and trusts all buy and sell property as well. In addition, a taxpayer can die or otherwise become incapacitated in the middle of a 1031 exchange. Likewise, a business entity can change form or structure in the middle of an exchange The Internal Revenue Service, or IRS, has clarified some of these situations as they pertain to a 1031 exchange.
Death of Taxpayer and Spouses
If a taxpayer dies during the completion of a 1031 exchange, the taxpayer’s estate may complete the transaction and still receive the benefit of the exchange. Transactions entered into by a husband and wife sometimes present issues as well. In community property states, for example, a taxpayer may create a bar to Section 1031 Exchange treatment without realizing it. If, for example, title to the relinquished property was originally held by only one spouse, but the other spouse is included on the title to the replacement property because of the community property laws, the transaction will not be recognized by the IRS as a 1031 exchange. In the eyes of the IRS, the spouse who owned the relinquished property has now gifted half of the replacement property to his or her spouse, meaning that the same taxpayer did not complete both ends of the transaction.
Another issues that sometimes arises with transactions involving an individual or a married couple is when a lender requires the formation of a separate business entity, such as a limited liability company (LLC). Revenue Procedure 2002-69 specifically addresses this issue as it applies to a married couple by treating a husband and wife LLC as a disregarded entity if the couple chooses to treat it as such for federal tax purposes. In practical terms, this means that a single taxpayer LLC, or a husband and wife LLC, may qualify to take title to the replacement property without violating the “same taxpayer” rule.
Trusts create another potential problem. Revocable trusts can relinquish title or take title without a problem in most cases because the property is still legally owned by the grantor, or the individual completing the exchange. An irrevocable trust, however, can create a problem because the property is not legally owned by the grantor once placed in the trust. In order for this scenario to qualify, the trust itself will have to take title to the replacement property as well as relinquish title to the original property.
Business entities can participate in a 1031 exchange; however, the exact same entity that relinquishes the property must take title to the replacement property. In Chase v. Commissioner, 92 T.C. 874 (1989), a partnership was involved in the exchange of an apartment complex. The complex was originally held by the partnership, but two of partners transferred ownership in contemplation of the sale to them as individuals. The replacement property was then titled in their names as well. Although the partners attempted to structure the transaction in a way that would meet the 1031 exchange requirements, the court held that the substance over form doctrine applied and did not allow Section 1031 treatment. In other private rulings, business entities that have changed hands or structure throughout the exchange process have been found eligible for Section 1031 treatment. The specific facts of the exchange are very important when a business entity changes form or structure during a 1031 exchange transaction when determining eligibility.
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