Key Considerations: “Same Taxpayer” Requirements for 1031
In order to obtain the benefits of exchange treatment, the same person who started the exchange must complete the exchange. While this seems simple enough, the manner in which title to the "relinquished property" was vested may, due to a variety of circumstances, differ from the manner in which title to the "replacement property" must be vested. The following are some of the most common circumstances that impact vesting of title in a 1031 tax-deferred exchange.
MARITAL/COMMUNITY PROPERTY ISSUES
In California and other community property states, community property issues often creep in when the Taxpayer is married, even if the exchanger acquired property in his or her name separately. For example: Timothy Taxpayer inherited a parcel of real property from his aunt prior to marrying his wife, Trisha. Throughout his marriage, the parcel remained his separate property. Timothy decides to do a 1031 tax-deferred exchange, and enlists the services of a Qualified Intermediary (QI). After the relinquished property closing, Timothy identifies replacement property and enters into a purchase and sale agreement with the seller. The escrow officer closing the replacement property asks Timothy how he will be taking title to the property; as a married man as his sole and separate property or if Trisha will be sharing in the ownership of the property. Timothy decides that title should be vested in himself and his wife as community property, so that upon the death of one of them the survivor will receive a "stepped-up basis" in the property and be able to avoid the capital gains tax. A grant deed is prepared and recorded conveying title to "Timothy Taxpayer and Trisha Taxpayer, husband and wife as community property"
Though Timothy and Trisha may be happy with their decision, the IRS is not. This is because Trisha is a separate Taxpayer from Timothy, and not a party to the exchange. From a tax point of view, when Timothy takes title to the replacement property with Trisha, he is considered to have made a gift to his wife of a half interest in what was, originally, 100% of his separate property. Both the IRS and the courts have taken the position that if replacement property is disposed of immediately after the exchange, the property would not be viewed as being held for a qualified purpose under IRC Section 1031. Specifically, the IRS has invalidated exchanges where the Taxpayer has gifted away all or a portion of the replacement property immediately following the exchange. Whether an immediate gift to one's spouse would invalidate an exchange has never been decided, but it is a risk that the Taxpayer may not wish to take.
When acquiring a replacement property that requires a new loan, the lender will require that certain conditions be met before funding the loan - conditions that sometimes cause vesting problems to arise in the exchange. For example, if an exchanger wishes to acquire title to property as an individual, but is relying on a spouse or parent's income to qualify for the loan, the lender will likely require that the spouse or parent appear on title to the replacement property.
However, if the spouse or parent is added to the relinquished property title to make the vesting consistent, the IRS can argue that the exchanger gifted away half of his interest immediately before the exchange, and is only entitled to tax-deferral on the remaining half interest that he is exchanging. To avoid this problem, an exception to the "same taxpayer" requirement can be utilized if a written agreement is executed stating that the co-signing spouse or parent is appearing on the loan documents in trust only, and that the replacement property is to be considered the exchanger's separate property because no gift is intended.
Lenders also commonly require borrowers to take title to the property that is collateral for the loan in the form of a newly created entity that owns only that property. That way, if the borrower files bankruptcy or a judgment is recorded against the borrower for something unrelated to that property, the lender is assured that the property is not affected, because the claims would appear in the individual's name, not the name of the new entity. For single exchangers, this can be accomplished by creating a single member LLC to take title to the replacement property. If a husband and wife are exchanging property, they can create one LLC with the husband and wife as the only members, provided the property is community property. For married exchangers acquiring property that is not community property, two LLC's are created, one that is owned by the husband and the other that is owned by the wife.
Conversely, some lenders prefer to loan to people in their individual names in situations where the person appears on title as a Trustee. If the Taxpayer is relinquishing property in the name of a Grantor Trust (Revocable Living Trust), there is usually no problem with the Taxpayer taking title to the replacement property in his individual name, since both the Taxpayer and the trust have the same taxpayer identification number. Vesting concerns arise when an exchange involves an irrevocable trust because such trusts often carry a different taxpayer identification number than the exchanger. To avoid this inconsistency, the Taxpayer/Trustee would be wise to confirm that the lender loans to a trust before starting the exchange.
A 1031 tax-deferred exchange becomes more complicated when the exchanger 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, 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. Other vesting problems that arise in a business entity context include the formation, merger and dissolution of corporations and LLCs. In two letter rulings, the IRS approved transactions involving related LLCs and corporations, the facts of one of these went basically as follows. An LLC transferred the "relinquished property", and after the transfer the following events occurred:
- The LLC was dissolved and its assets distributed to its corporate parent;
- The corporate parent merged with an affiliated corporation;
- The affiliated corporation (the surviving corporation after the merger) then formed a new LLC; and
- The new LLC acquired the replacement property.
Because the LLCs at both ends of the transaction had elected to be "disregarded entities" their parent corporation was considered the Taxpayer. When the corporations were merged together they became the same taxpayer, so throughout the exchange the same Taxpayer was involved. Private letter rulings are binding upon the IRS only as to the particular Taxpayer involved and may be modified or revoked even as to that Taxpayer. A Taxpayer should definitely consult with an attorney and/or CPA before structuring any exchange in which the form of the business entity involved will be altered to ensure that there will be no problem with consistency of vesting on the relinquished and replacement properties.
There are numerous other scenarios that could 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 there is a corporate merger/reorganization or partnership/limited liability company conversion during the exchange period, as briefly discussed above. 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 vested in the same Taxpayer.