There are exceptions where legal title is not required to be identical
Unraveling The Mystery Of 1031 Exchanges
Unraveling the mystery of 1031 exchanges and some exceptions for the taxpayer and rules on the same taxpayer.
In a 1031 exchange transaction, it is often said that legal title to the real estate being sold (i.e., the relinquished property) and the real estate being purchased (i.e., the replacement property) must be held under the exact same legal title.
This is a common misconception. Although it is generally recommended to hold legal title to properties in a 1031 exchange under the exact same legal title, there are exceptions where legal title is not required to be identical.
Same Taxpayer Requirement
The actual requirement is that the ownership (i.e., the taxpayer) of the relinquished and replacement properties in a 1031 exchange must be held by the “same taxpayer” regardless of how legal title is held. The same taxpayer must sell the relinquished properties and buy the replacement properties.
This same taxpayer requirement is an implicit requirement that is not specifically mentioned in the Internal Revenue Code or Treasury Regulations. Legal title may vary from the sale of the relinquished property to the purchase of the replacement property if the property ownership continues to be held by the exact same taxpayer.
This is one of many reasons why investors should discuss their proposed 1031 exchange with their legal, tax and financial advisors before proceeding with their transaction.
Exceptions – Disregarded Entities
There are several ways an investor can acquire and hold legal title to real estate while still meeting the same taxpayer requirement. Generally, this is achieved by using a disregarded entity. Disregarded entities are entities that are ignored for Federal tax purposes (i.e., they do not file a Federal Tax Return) and are treated as if the underlying investor is the actual taxpayer.
The following are individuals or disregarded entities that will be treated as if the properties were owned or held by the same taxpayer:
- Individual name
- Single-member limited liability company (LLC) that has not elected partnership or corporation treatment for Federal tax purposes (i.e., it is a disregarded entity)
- Fully revocable grantor trust (e.g., living trust)
- Title holding trust (land trust) [Revenue Ruling 92-105]
- Tenant-in-common (TIC) ownership structure [Revenue Procedure 2002-22]
- Delaware statutory trust (DST) [Revenue Ruling 2004-86]
Examples Using Disregarded Entities
Lenders often require legal title of the replacement property to be held in a specific way for them to complete the financing. Many lenders do not allow legal title to be held in a trust or a LLC, while other lenders may require legal title to be held in an LLC.
For instance, an investor may hold legal title to his or her relinquished property in an LLC, but the lender may insist legal title to the replacement property be held in the investor’s individual name to complete the financing.
This will meet the same taxpayer requirement if the LLC is a single-member LLC and disregarded entity for Federal tax purposes. The LLC is ignored and treated as if the underlying individual is the owner for Federal tax purposes and therefore considered to be the same taxpayer.
Similarly, an investor may hold legal title to his or her relinquished property in a fully revocable grantor trust (i.e., living trust, title holding trust or land trust), but the lender may require legal title to the replacement property be held in the investor’s individual name to complete the financing.
This will also meet the same taxpayer requirement if the trust is a disregarded entity for Federal tax purposes. These trusts are ignored and treated as if the underlying individual is the owner for Federal tax purposes and therefore considered to be the same taxpayer.
Death of Taxpayer During 1031 Exchange
If the taxpayer dies during a 1031 exchange, the Treasury Regulations require the taxpayer’s estate to complete the 1031 exchange transaction to receive tax-deferred exchange treatment. In fact, the taxpayer’s estate must complete the 1031 exchange to receive a step-up in the cost basis.
Non-Disregarded Entities
Entities that are not classified as disregarded entities for Federal income tax purposes (i.e., they are regarded entities), include, but are not limited to:
- Limited liability companies (LLCs) treated as partnerships or corporations
- General partnerships
- Limited partnerships
- Corporations (both sub-chapter “C” and “S” corporations)
- Irrevocable trusts
Legal title to the relinquished and replacement properties must generally be held in the exact same legal title (i.e., in the regarded entity name) when the entity is not disregarded for Federal tax purposes.
Legal, Tax and Financial Advisor Review
The requirement to have the same taxpayer vs. the way legal title is held is very complex. It is crucial for investors to have their legal, tax, and financial advisors examine their proposed 1031 exchange to ensure the same taxpayer requirement is met. If the taxpayer is not deemed to be the same, the 1031 exchange could be disallowed.
Source: Rental Housing Journal
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