Understanding the misconceptions of this topic is important as it becomes an issue with many tax deferred exchanges. Many who are familiar with the Internal Revenue Code Section 1031 are under the impression that the vesting on the replacement property in an exchange must coincide with the vesting on the property sold. For structuring purposes, many exchange facilitators make this conservative statement to their clients but the rule is not applicable to all exchanges. Rather, the IRS requires the “tax ownership” (taxpayer) of the relinquished property also remain the same on the replacement property. However, tax ownership does not necessarily correspond to the same legal entity name. There are a variety of ways the same taxpayer, under different legal entities, can utilize the benefits of certain Trusts and Business Entities which are disregarded for federal income tax purposes. Being able to use these different vesting options provides taxpayers with a greater opportunity to fulfill their personal investment goals which includes reducing their legal and tax liabilities.
There are three different ownership classifications to take into account:
1) Vesting
2) State Tax Ownership
3) Federal Tax Ownership
Here is a simple example to better understand the above ownership types. Debra Jackson holds title to an investment property under only her name. In this case, even though Debra is the sole individual on title, under state and federal tax law she might not actually own the property if she simply holds title for the benefit of her daughter, Jessica Jackson (the owner). Instead of being the tax owner, Debra is actually the record title holder of the property being made through a nominee arrangement with her daughter. If Debra sells or exchanges the property as nominee for her daughter, then the capital gain tax liability would fall through to Jessica.
Matters become a bit more complicated when dealing with legal entities and trusts. For example, state law ownership is attached to a limited liability company, but the actual taxpayer might differ. To determine the taxpayer in a case like this, it depends on how the LLC has elected to be taxed for federal income tax purposes. If the LLC has more than one member and has elected to be taxed as a corporation or partnership, then tax ownership would be attached to the company. However, if an LLC has only one sole-member then the entity would be disregarded for federal income tax purposes and the tax liability would fall through to the individual. The IRS deems a single-member limited liability company as a “disregarded entity” and any assets owned under the LLC are treated as being owned by the sole member of the company.
As for a revocable trust, it is similarly treated like a single-member LLC. A person who forms a revocable trust (a Grantor) is deemed as the tax owner by federal law. Any assets owned under a revocable trust have a tax liability directly attached to the grantor and not the trust itself. Even though the trust is an entity under state law for the purpose of vesting and ownership, it is treated as a disregarded entity for federal income tax purposes. As an example, Jim Mueller entered into a 1031 exchange and sold an apartment building he held in his revocable trust where he was the grantor and sole trustee. A few weeks later he located a potential replacement property which he decided he wanted to purchase in his own name and not in the trust. Being that the trust was revocable and for federal tax purposes Jim was the the underlying taxpayer, he was able to change the vesting and complete his purchase under his individual name.
Changes in vesting can be very complex and could trigger negative tax consequences if not structured properly. CR Capital 1031 is not authorized or permitted under applicable laws to provide tax or legal advice. If one does not have in depth knowledge of the federal tax laws, it is highly advised that you obtain competent legal and/or tax advice from a licensed professional before making any changes to ownership vesting when doing a 1031 exchange.