Narrow Deviation Allowed in 1031 title holding requirement

One of the critical requirements for a 1031 exchange is the same taxpayer must hold title to both the Old and New Properties in the exchange. While the exact amount of time these properties must be held is not defined by the IRS, it is clear that it has to be the same taxpayer, and both properties must be held for investment.

If Fred and Sue, for example, own an apartment building they are selling as joint tenants, and buy a replacement property for their exchange as joint tenants, then clearly the exchange involved the same taxpayers since Fred and Sue were on title for both the Old and New Properties. But what if Fred and Sue wish to protect themselves by putting the New Property into an LLC as soon as they acquire it? Most attorneys would say that was a smart business decision and quickly set up the LLC for them.

...if you have control over a transaction . . . the IRS could view your transaction as a violation...

The problem is when the attorney transfers the New Property into the LLC, he has just changed the taxpayer, because an LLC with more than one member files a tax return. This would obviously have a different tax identification number than Fred or Sue’s. Typically, the attorney’s justification for restructuring ownership of the property in this way, is Fred and Sue still control the property, just in a different legal entity. They would think that any violation of the 1031 rules would be a mere “foot fault,” and would certainly not cause their exchange to be disallowed. Unfortunately the attorney is wrong, and what he’s just done could toast the exchange.

Don’t get me wrong, I am not criticizing the attorney. After all, he’s on the frontlines trying to protect his clients from dangers much more real then the perceived threat from the IRS if the exchange isn’t handled correctly. It’s just that the threat is more real than they believe it is. The IRS has just released a Private Letter Ruling which illustrates my point.

In PLR 200651030, the taxpayer was a Trust set up to handle the real estate portion of an estate of a gentleman that died many years ago. Under the laws of the state where the trust was set up, it was due to expire shortly. The beneficiaries of the Trust were his heirs (actually the heirs of his heirs). What the attorneys for the Trust proposed was to set up an LLC where the members were the same beneficiaries with essentially the same interest as they held in the trust. Upon the expiration of the Trust, the assets will be transferred from the trust to the LLC.

This ruling became an issue under Section 1031 because of the Trusts many properties. Two were under contract to sell and exchange soon after the scheduled transfer to the LLC. Since the Trust and the LLC will have different tax identification numbers, they wanted assurance that the IRS would not disallow those exchanges.

The IRS allowed their plan because the beneficiaries would have the same ownership interest in the LLC as they had in the Trust, and because the beneficiaries had no control over the termination of the trust – the date of which was set more than 20 years ago. It was also helpful that the trust has a history of doing 1031 exchange and the managerial and operational structure of all the properties will carry over to the LLC. All of which helped to give the IRS comfort that this was not a scheme designed by the Trust attorneys to get around the ownership requirements of Section 1031.

For those of you reading this article who customarily advise clients on structuring real estate transactions involving 1031 exchanges, the important point is that the taxpayer had no control over the transaction. The Trust was scheduled to terminate by point of law. The implication is obvious: if you have control over a transaction which results in the change of taxpayers (i.e. change of tax identification numbers), the IRS could view your transaction as a violation of the same taxpayer rule.