If you're married, you probably know if you live in one of the nine current community property states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, or Wisconsin. These states have laws stating that property acquired by a married individual is owned in common with that individual's spouse. Those laws can extend to profits from an LLC owned solely by two people married to each other.
Special Rule for LLCs owned by Spouses in Community Property States
The IRS has issued a special rule applicable to LLCs owned by married couples who live in community property states. Under this rule, a married couple can treat their jointly owned business as a disregarded entity for federal tax purposes if:
the LLC is wholly owned by the husband and wife as community property under state law
no one else would be considered an owner for federal tax purposes, and
the business is not otherwise treated as a corporation under federal law.
In most cases, this would mean that the spouses would file a joint tax return and include with that return a Schedule C, and any other relevant schedules for their business. For all practical (tax) purposes, they would prepare their taxes as though their LLC were an Single-Member LLC. This includes same-sex couples who are legally married under state law.
If a married couple does not meet the requirements of the IRS special rule, then their jointly-owned LLC would be treated like any other multi-member LLC which means it would be taxed as a partnership, not as a disregarded entity. As a partnership, an LLC has additional tax reporting requirements that don't apply to a disregarded entity, such as filing a partnership tax return.
Divorce Complications
Divorce can also complicate a 1031 exchange that is in process or one that is planned. If the divorce paperwork has been filed, then the parties will have to get a judge’s approval to sell or buy property until the final divorce decree is issued by the court. Once the assets have been properly transferred, the party receiving the investment real estate can sell and complete an exchange. So, in summary, if a transaction is already underway or about to begin, it’s important to consider completing the exchange before filing for divorce. If not, it may be best to wait until all property transfers per the court approved settlement agreement (known as a decree or judgement).
In an example, David has agreed that as part of their divorce settlement Ashley will receive the 40 acres of highly appreciated land they bought together. Ashley wants to sell and exchange into income property because she needs the cash flow. In order to preserve the benefits of the 1031 exchange, Ashley should speak with a tax professional and consider waiting until the final decree has been issued by the court and David deeds his interest in the property to her before selling and starting the exchange.
*If you are considering a 1031 exchange it’s important you obtain professional tax or legal advice from an Advisor, CPA, or Attorney who understands the applicable state and federal laws. CR Capital 1031 cannot give tax or legal advice and does not intend to under any circumstances.