A Look At Ownership Issues in a 1031 Exchange

A basic rule of 1031 exchanges is that the taxpayer who owns the old property must be the one that does the exchange and takes title to the replacement property. For example, if Fred Jones owns the old property, Fred Jones must be the one who takes title to the new property—he can’t take title as Jones Investment Corporation because the corporation is a different taxpayer.

While that seems fairly straight forward, there are some aspects that can be confusing. For example, suppose Sue owns a rental condo before she and Fred got married but she didn’t add Fred to the title after they were married. Now she’s selling the condo and wants to exchange into another rental property and add Fred to the title of the new property. This exchange would be disallowed because the IRS could rule on audit that she only bought half of the new property (and Fred bought the other half).

The ownership issues to be considered when doing a 1031 exchange—more than even the most savvy real estate investor realizes . . .

Likewise, if Fred and Sue (husband and wife) own the old property they have to buy the new property also as Fred and Sue – meaning that Fred could not buy the new property using section1031 in his name only. They are considered the same taxpayer for IRS purposes because they file a joint return (even if they file as married-filing-separately). You now get the same answer with same sex married couples – even if they reside in a state that does not recognize same sex marriages because the IRS has ruled that if they are legally married, they’re married for tax filing purposes no matter where they live. So if Sally and Mary do an exchange with their old property, then Sally and Mary must take title to the new property, even if they live in a state that doesn’t recognize their marriage, or the property is in a state that doesn’t recognize their marriage.

You get a completely different answer, however, if the people aren’t married. For example, let’s say Sally and Mary are sisters and the property they’re selling is a rental property they inherited from their parents many years ago. Now you have two completely different taxpayers that own the old property and each taxpayer may choose to do or not do a 1031 exchange regardless of what the other taxpayer does. Sally could do an exchange with her half and exchange into another investment property while her sister Mary could take her half of the cash and pay the tax.

What about entities? 
Well, you get the same answer. Regardless of whether the old property is owned by a corporation, an S-Corp., an LLC, a partnership or a trust, the taxpayer that owns the old property is the same one that must do the exchange and take title to the new property. This means that if the FGH Partnership owns the old property, Fred can’t buy the replacement property is his name, even though he owned a third of the partnership. This is because he is not the taxpayer that held title to the old property – the partnership was. And taxpayer means: the entity that files the tax return, even though some entities, like partnerships and LLCs, don’t actually pay a tax.

One last ownership issue I should mention: certain entities that are owned by a single person are disregarded—they don’t file a tax return and the income and expenses from the property are reported in the tax return of that sole owner. For example, if Sue Jones holds title to her investment property in Jones Investments, LLC, and Sue is the sole owner of Jones Investments. Jones Investments does not file a tax return; Sue reports the income and expenses in her IRS Form 1040. That means Sue herself is the taxpayer that owns the old property and she could sell it, do an exchange, and buy the replacement property in her own name (because it’s her tax return).

And finally there are four additional entities that are considered disregarded for 1031 exchange purposes: Single Member LLCs, Revocable Living Trusts, Illinois Type Land Trusts and Delaware Statutory Trusts. There are many other ownership issues to be considered when doing a 1031 exchange than even the most savvy real estate investor or professional realizes. That is why it is important to consult with a seasoned 1031 exchange expert when you consider doing a tax-deferred exchange.