Mirror Image in 1031s: Questions on the "Same Taxpayer" Rule
One of the basic rules to complete a successful 1031 exchange is that the taxpayer selling the relinquished property must be the same taxpayer that buys the replacement property. There are times, however, when the party selling the relinquished property wants or needs to make a change in how the replacement property will be held or titled. A common example includes a taxpayer's desire to change from direct personal ownership in their individual name to entity ownership in an LLC for greater liability protection. Sometimes, it’s the lender on the replacement property acquisition that requires that the borrower be an entity instead of an individual. Can you change the ownership entity for the replacement property and still have a valid exchange?
Happily, the answer is yes. A taxpayer can sell property in their personal name and then set up a new single-member LLC (SMLLC) that can be used to acquire the replacement property. When established correctly, a SMLLC is treated as a pass-through entity with all tax reporting going directly onto the taxpayer's personal tax return. In fact, the tax ID is usually the taxpayer’s social security number, so there is no need to file a separate return for the LLC. We refer to this type of entity as a "tax nothing but legal something."
The IRS has weighed in on this topic many times and found consistently that the use of this type of "pass-through" entity is not in conflict with the "same taxpayer" rule required in an exchange. Use of a single-member LLC or other similar entity gives exchangers greater flexibility should they want increased liability protection or need to satisfy the requirements of a lender. For further reference, please see PLR 9807013 and PLR 00118023.
There are other types of entities that have this same “tax nothing but legal something” characteristic and also do not file a separate return. Grantor trusts and revocable trusts fit this description and are commonly used for estate planning purposes.
In short, if the deed to the taxpayer’s relinquished property (the property being sold that begins the exchange) is titled to an entity that files a separate tax return or has a different tax ID number or distributes a K-1, then it is a separate tax entity. In these instances, in order to have a valid exchange, the taxpayer must buy the replacement property using that same entity or at least under the same tax ID number.
Lastly, there are instances where a husband and wife would like to change how the title to an investment property is currently held. Outside of an exchange, this type of ownership adjustment between spouses who file a joint tax return can be done without triggering any tax consequences. But what happens if the couple is considering or already doing a 1031 exchange? If only one spouse is the seller of the relinquished property, then the same spouse should be the buyer of the replacement property. However, there may be a way to add the other spouse if the replacement value needed to get total gain deferral is exceeded. For example, if Jane sells a property that is solely in her name for $500,000, and then buys replacement property for $500,000, then Jane (or a pass through entity owned by Jane as described earlier) must be the only party on title to have a valid exchange. But if Jane instead elects to buy a replacement property for $1,000,000, then she could add her husband Bob to the title as 50% co-owner. All that Jane needed to replace was $500,000, so the extra value greater than that amount could be allocated to Bob.
However, let’s assume that Jane is not going to buy a property of a higher value and keeps her replacement acquisition at $500,000. Could she not, just before or just after the exchange, transfer a 50% interest to Bob to solve this problem? The answer is unclear as both the 1031 and the tax community is divided on this topic. Some feel that this type of transfer should occur 1-2 years before or after the exchange and must comply with some “holding period” standard. Others feel that because of the right that spouses have to transfer unlimited amounts of assets back and forth outside of an exchange, the “holding period” standard should not apply.
The devil is in the details when dealing with same taxpayer issues. Although we have covered what typically happens, there are always exceptions. It is important that you talk to your tax advisor when you face these challenges in order to take advantage of the many benefits that a 1031 exchange offers.