Vesting and 1031 Exchanges - Same Taxpayer Rule
In order to qualify for tax deferral treatment under Internal Revenue Code § 1031, the taxpayer that sells relinquished property in an exchange must also purchase the replacement property. For example, if Alex Smith sells relinquished property as an individual, Alex Smith must also acquire the replacement property. While a simple concept in theory, investors often overlook this important detail. A variety of circumstances can arise under which vesting of the replacement property must differ from the relinquished property’s original vesting. In some cases, there are certain exceptions to the general rule that can be utilized to meet the “Same Taxpayer” requirement, as outlined below.
To comply with the general rule, the investor should confirm how title to the property to be disposed of (the “relinquished property”) is held and plan to acquire the new property (the “replacement property”) using the same form of ownership. For example:
Exception - Disregarded Entities
It is not always feasible for the same party to sell the relinquished property and acquire the replacement property. For example, a loan might be required for the purchase of the replacement property, and the lender may require that a newly created entity take title. Or, if the Exchangor is a business entity, there may be a business need for the replacement property to be held in a different entity than the entity that sold the relinquished property.
Taxpayers can work around the general rule described above by utilizing “disregarded” entities for their acquisition of replacement property. Disregarded entities exist for legal purposes, but are completely ignored for tax purposes. For example, if Maria Sanchez sells investment property as an individual, she can purchase replacement property in her name individually or in the name of her revocable grantor trust, since a revocable grantor trust is treated as disregarded for income tax purposes (i.e. Marie is considered the taxpayer). Maria can also acquire the replacement property using a single-member limited liability company (“LLC”) wholly owned by her, which is also treated as disregarded. In each of these scenarios, for purposes of Maria’s 1031 exchange, the Same Taxpayer rule will be satisfied.
Community Property and Disregarded Entities
Typically, an LLC may only be treated as disregarded to satisfy the above exception if it is wholly owned by a single taxpayer. Thus, in many circumstances, a married couple who own a relinquished property together as individuals cannot acquire title to the replacement property in an LLC owned by them together and satisfy the Same Taxpayer rule. The LLC owned by them together would be treated as a partnership for income tax purposes and considered a separate taxpayer from its owners. However, this is not the case when a married couple resides in a community property state. If a married couple resides in a community property state, they may satisfy the Same Taxpayer rule by acquiring their replacement property in an LLC wholly owned by them as their community property – that LLC is considered disregarded for income tax purposes.
In the above example, if Maria is married and Maria and her spouse own the relinquished property, they can buy the replacement property using either a revocable trust in which they are both grantors; or, assuming they reside in a community property state, they may acquire the replacement property in an LLC in which they are the only two owners.
A 1031 tax-deferred exchange becomes more complicated when the Exchangor is a business entity, such as a partnership or corporation. Though a partnership may exchange its real property for other real property to be owned by the partnership, its individual partners cannot exchange their partnership interests for other real property. This is because partnership interests are specifically excluded from exchange treatment under Internal Revenue Code Section 1031.
Likewise, a taxpayer cannot acquire an interest in a replacement property by way of an ownership interest in an LLC or a partnership owned by multiple parties. As outlined above, an LLC with multiple members is considered a separate taxpayer from its members, and, the acquisition of a membership or partnership interest is excluded from exchange treatment. Instead, a taxpayer may acquire an interest in a replacement property (either directly or through its own disregarded entity) as a tenant in common with the other parties. This way, the interest in the replacement property is acquired directly by the taxpayer in the exchange, and the Same Taxpayer rule is satisfied.
A business entity may acquire title to the replacement property as the sole member of a new LLC. So long as the LLC is wholly owned by the business entity that sold the relinquished property, the Same Taxpayer requirement will be met.
In many cases, a disregarded LLC sells the relinquished property, and its sole member (the taxpayer) may desire to acquire title to the replacement property in a new disregarded LLC wholly owned by the same taxpayer. This is an acceptable way to meet the Same Taxpayer requirement.
There are numerous other scenarios that illustrate the importance of consistency of vesting in a 1031 tax-deferred exchange, and there are other exceptions to the Same Taxpayer requirement that may apply, such as when the taxpayer dies (in which case the taxpayer's estate or trustee may complete the exchange), or when there is a corporate merger/reorganization or partnership/limited liability company conversion during the exchange period. The basic rule to remember is that no tax deferral will result if the relinquished property disposed of and the replacement property acquired are not ultimately owned by the same taxpayer. Taxpayers should always remember that it is essential to discuss any transaction with a tax advisor prior to the sale of their relinquished property to ensure they are tackling this important issue, as well as any other issues that could arise in their exchange.