One of the basic rules of a 1031 exchange requires, with limited exceptions, the taxpayer that will hold title to the Replacement Property must be the same taxpayer that held title to the Relinquished Property. Married couples can face some challenges to the “same taxpayer” rule, therefore it is important to plan ahead with the help of your tax advisor.
Adding a party to vesting, such as Relinquished Property held by husband, with Replacement Property acquired by husband and wife, can result in partial recognition of gain by the exchanger husband. If property is held by a husband and wife jointly on the title when they sell the relinquished property then both of the spouses should be on the title when buying replacement property.
In a technical advice memorandum (TAM 8429004), a relinquished property was sold by both husband and wife as tenants in the entirety, and the replacement property was acquired solely in the husband’s name. The IRS ruled that since the wife was not on deed to the replacement property, she was deemed to have gifted her share of the proceeds to her husband thereby failing her exchange and required to report 50% of the gain on the sale of the property. However, this TAM pre-dates the current version of IRC §1041, which provides for non-recognition of a gain or loss on a transfer of property between spouses or a transfer incident to a divorce. As of 2020, the IRS has not provided guidance directly addressing how §1041 would or would not comport with the “same taxpayer” rule of §1031. Taxpayers are encouraged to discuss this issue with an advisor.
In a “trade-up” exchange, the non-exchanging spouse may acquire an interest in the replacement property if the replacement property value exceeds the value of the relinquished property. For example, if the wife (exchanger) sold the relinquished property for $500,000 and the replacement property will cost $1,000,000. The husband can purchase the property as tenants in common with 50% acquired by the wife as her replacement property and 50% acquired by the husband as a new purchase. This type of ownership vesting must be discussed with your tax advisor prior to planning your exchange.
Many taxpayers seek to purchase replacement property in an LLC to add a layer of liability protection. The taxpayer can acquire a replacement property in a single member LLC which can be deemed disregarded for tax purposes and it will comply with the same taxpayer requirement. However, If more than one person is a member of an LLC it will likely be taxed as a partnership and will be considered a separate taxable entity from its owners. Therefore, if a married couple in a non-community property state sell a property as individuals, they cannot simply acquire the replacement property in one LLC, but rather they would need to set up two single member LLC’s, one for each spouse. Unfortunately, this results in a doubling of LLC filing fees, registered agent fees and annual LLC maintenance fees.
There is an exception to this rule provided by Rev. Proc 2002-69, which holds that the IRS will consider an LLC owned solely by a husband and wife as community property to be a disregarded entity. This only applies in the community property states, including Louisiana, Texas, New Mexico, Arizona, California, Nevada, Washington, Idaho, and Wisconsin.
CR Capital 1031, LLC does not provide tax or legal advice, nor can we make any representations or warranties regarding the tax consequences of your exchange transaction. Exchangers must consult their tax or legal advisors for advice and clarification on tax rules.