Mirror, Mirror: The Same Taxpayer Rule in 1031 Exchanges
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. One common example is when a taxpayer prefers to own the property through an entity for greater liability protection or to keep their name out of the public record, rather than hold it in his or her personal name. Or, an investor may be selling a small property, but want to be part of a group that buys a larger replacement property. Finally, when property that was owned prior to a marriage is sold, there are a number of couples who want a path to get from “me” to “we”.
Happily, there are solutions for each of these “same taxpayer” dilemmas. Investors 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, an SMLLC is treated as a “disregarded” entity in that all the tax reporting goes directly into the taxpayer’s personal tax return; most often, the tax ID number is even the person’s social security number. There is no need to file a separate tax return, but the additional liability protection of entity ownership is provided. We refer to this type of entity as a “tax nothing, but legal something.” Grantor trusts are also pass-through entities that do not file a separate tax return. Both single-member LLCs and grantor trusts are relatively easy to establish and maintain.
The IRS has weighed in on this topic many times and consistently found that the use of this type of “disregarded” entity is not in conflict with the “same taxpayer” rule required in a 1031 exchange. Use of a single-member LLC gives exchangers greater flexibility should they want to increase liability protection or satisfy the requirements of a lender. For further reference, please see PLR 9807013 and PLR 00118023.
Another common challenge occurs when a taxpayer has sold his relinquished property, but would prefer to join with a number of other people in order to buy a larger replacement property. Many times the group investing is forming a multimember LLC to use as the ownership entity. This type of LLC, that has more than one member, files a partnership return. The taxpayer is purchasing an interest in the partnership, which owns the property, but they do not own a direct interest. Unfortunately, this replacement property ownership structure does not provide a proper option for purchasing replacement property without violating the “same taxpayer” rule. Additionally, a partnership interest is a type of ownership interest that will not qualify for a 1031 exchange. What to do?
The solution is for the investor to purchase the property alongside the partnership in a structure in which the partnership and the taxpayer each own an undivided tenant-in-common interest (TIC). After the exchange is complete, the investor may consider contributing his TIC interest to the partnership in exchange for a partnership interest. Many tax advisors recommend that some time should pass before this last step is completed.
Lastly, husbands and wives can face some “same taxpayer” rule challenges as well. It is not uncommon for one party to have owned a property prior to getting married. If, several years after tying the knot this property is sold, the couple may have to make some changes if they want the replacement property in both their names. However, if no changes are made before the sale takes place, then the spouse that holds the title to the property must be the only one that is the buyer of the replacement property.
The best way to tailor the ownership to match the couple’s objective is to make whatever changes are needed before or after the exchange. For example, consider a wife who solely owns a rental property. If she and her husband want to equally own the replacement property, prior to the property being sold, she needs to deed a 50% interest in her existing property to her husband. Or alternatively, she can purchase the replacement property solely in her name, and later, deed an interest in the new replacement property to her husband. Some tax professionals feel that some time should pass between the time these transfers are made and the property is either sold or new one acquired. Lastly, if the replacement property is more expensive than the relinquished property then both husband and wife can be on the deed. But the deed must list her percentage of ownership and it must equal or exceed the price of the property she sold/the relinquished property.
Owing real estate is complicated, and can pose some entity issues when completing a 1031. But there are solutions to help investors align their objectives while still complying with the “same taxpayer” rule. While some of these solutions may seem simple, it is always best to check with your tax professional before moving forward.