In order to qualify for tax deferral under IRC Section 1031, the same taxpayer who owns and sells the relinquished property must be the same taxpayer who acquires the replacement property (emphasis that there must be continuity of tax ownership on both sides of the exchange).
This means that absent an exception through another provision of the Tax Code, the Exchanging Taxpayer (“Exchanger”) cannot simply assign proceeds of sale to another taxpayer who did not historically own the relinquished property. Proceeds of sale assigned to a 1031 intermediary generally consist of adjusted basis and gain which has been attributed to the tax owner of the property.
The concern with respect to 1031’s same taxpayer rule is one of tax ownership. The IRS explains it well in the material linked here. The concern regarding the 1031 same-taxpayer rule centers on tax ownership. The IRS explains this well in the material linked here: Same Taxpayer Requirement. This concept is less about whose name appears on the property title or even the EINs/TINs, and more about how the property is reported on tax returns. This article provides non-exclusive examples of scenarios that comply, or fail to comply, with the rule as a point of reference. Many of these situations are not obvious to those unfamiliar with the underlying tax principles.
Your go-to person for advice in this scenario is your accountant or financial advisor, as they know how your taxes are filed and are in the best position to advise and confirm that this requirement is met. That being said, this article seeks to provide you with the preliminary information you may need to facilitate a productive conversation with your advisors. Kindly take note that as your qualified intermediary, Legal 1031 is unable to provide tax or legal advice and cannot make determinations for you regarding this requirement or regarding the underlying tax classification of your existing entity.
The same taxpayer rule governs how the relinquished and replacement properties are held on both sides of the exchange. For example:
| Relinquished Property Taxpayer on Title | Replacement Property Taxpayer on Title |
|---|---|
| Individual or single member LLC | Individual or single member LLC |
| Husband and wife as co-owners | Husband and wife as individual co-owners |
| Partnership | Partnership (or disregarded entity) |
| Corporation | Corporation (or disregarded entity) |
| If 3 separate taxpayers are on title as co-owners (Corporation, Partnership, and Individual) … | Each taxpayer must acquire and be on title of the replacement property. Each taxpayer may purchase a separate replacement property OR two or more taxpayers can purchase one replacement property together as co-owners of undivided fractional interests (%). |
The above illustrations of transfers of property are subject to advanced topics such as drop and swaps, disregarded entities, and more. Please refer to the articles linked below on advanced topics.
- Disregarded Entities (See Below Discussion and examples)
- Drop and swap and Swap and Drops (coming soon!)
- Spouses and Same Taxpayer check out our webpage here
Disregarded Entities and the Same Taxpayer Rule
An option referred to in the above table is a disregarded entity (DRE). A “disregarded entity” is one that is disregarded or ignored for federal tax purposes. (It is important to note that a single-member LLC (SMLLC) can elect otherwise per the IRS “check the box” regulations,[1]In the case where a SMLLC; is disregarded by the IRS disregards the LLC as an entity separate from its single member, then that member would report the LLC’s income and other tax attributes on their own tax return.[2] Generally, this tax classification does not affect the character of the entity for other legal purposes (i.e. limited liability and personal liability). Some trusts, like revocable grantor trusts can also be disregarded for tax purposes. To illustrate this, if NY LLC (a disregarded entity for tax purposes) is selling title to the relinquished property, then NY LLC or its sole member must be the same taxpayer acquiring the replacement property. However, if the exchanger wishes to add a friend to NY LLC during the exchange and before acquiring the replacement property, such an addition may change the LLC’s tax structure (thus creating a new tax partnership per Rev. Rul. 99-5)[3], thereby violating the same taxpayer rule.
Likewise, an LLC that is disregarded for tax purposes and has a single owner should be cautious regarding adding additional members prior to a planned exchange. Taxpayers should consult their accountant or a tax professional regarding the potential tax impact of creating a new tax partnership in situations where an individual or SMLLC has historically owned the relinquished property.
Co-ownership arrangements, fractional ownership in title, such as tenancy in common (TIC) or Delaware Statutory Trusts can provide for an optimized exit strategy from a real estate investment using a 1031 exchange. With the availability of a disregarded entity (DRE) to be utilized as a real estate holding company in a 1031 exchange, consider it in respect to the co-ownership example in the chart above:
If the relinquished property title (Property 1) is held by 3 separate taxpayers as co-tenants:
“A” Corporation 33% tenancy in common (TIC)
“B” Partnership 33% tenancy in common (TIC)
Jane Doe as an individual 33% tenancy in common (TIC)
Then an interest in title to a replacement property must be acquired by each distinct taxpayer:
“A” Corporation (or a DRE, wholly owned by A Corporation)
“B” Partnership (or a DRE, wholly owned by B Partnership)
Jane Doe (or a DRE, wholly owned by Jane Doe, as an individual)
Key Take – exchanging taxpayers are not locked into purchasing one property together by virtue of a co-ownership arrangement with respect to title of the relinquished property. The exchanging taxpayers can buy together as tenants in common again or they can buy separate properties.
Example: as a separate taxpayer, “A” Corporation can acquire Property 2 as a replacement property using its 33% share of the net proceeds from the sale of Property 1 separately from the replacement properties acquired by “B” Partnership or Jane Doe.
“A” Corporation sells its 33% interest in Property 1 it acquires 100% interest in title to Property 2 to satisfy its exchange.
“B” Partnership can also act as a separate seller for 1031 exchange purposes and sell its 33% interest in Property 1 as relinquished property and acquire any other real property interest eligible for an exchange.
Replacement Scenario 1:
“B” Partnership buys a 100% interest in title to real property, Property 3, which is net leased to a corporate tenant. Additional cash or debt can be added to transact the purchase. Jane Doe attempts her own exchange but does not find replacement property in which to reinvest and does not defer recognition of her gain. She reports income on her own personal tax return. Her failure to complete an exchange does not affect other co-owners, “A” or “B”.
Replacement Scenario 2:
“B” Partnership instead buys as a co-owner in Property 3 with Jane Doe as tenants in common. Additional cash or debt can be added to transact the purchase if it follows pro-rata rules of tenancy in common structures. The co-owners do not have to use a 50/50 allocation or even the same allocation as “B” had in the relinquished property (33%). Their goal should be to replace all value, equity and debt in the exchange, as described in this “Balancing the Exchange”.
Partnerships: If the exchanging taxpayers were all partners in a tax partnership or shareholders in a corporation, and that entity sold real property, then there should not be a separate purchase by a taxpayer other than the entity, meaning purchases by individual partners or shareholders would be problematic absent valid restructuring of the partnership to sell separately as TICs. For example, a drop and swap or similar strategy that would allow individual taxpayers to sell separately.
It should be noted that although ownership structures may change with respect to the title, it is still possible to maintain the tax identity. Of course, holding title in the taxpayer’s name individually is perhaps the most common form of ownership, however if properly structured, title in the replacement property may also be held in the following ways while still preserving the tax identity: as a single-member LLC, as a Tenant in Common (TIC), or under a Delaware Statutory trust (DST). Always be sure to consult with your tax or legal advisors to ensure that the same taxpayer requirement is met when considering a 1031 exchange.
Legal 1031 Exchange Services LLC does not provide tax or legal advice, nor can we make any representations or warranties regarding the tax consequences of any transaction. Taxpayers must consult their tax and/or legal advisors for this information. Unless otherwise expressly indicated, any perceived federal tax advice contained in this article/communication, including attachments and enclosures, is not intended, or written to be used, and may not be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any tax-related matters addressed herein.
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[1] See Treas. Reg. 301.7701-3(b), the IRS “Check-the Box” regulations provide guidelines for the classification of corporations, partnerships, and disregarded entities.
[2] Per the IRS, “An LLC that is not automatically classified as a corporation and does not file Form 8832 will be classified, for federal tax purposes under the default rules . . . An LLC that has one member will be classified as a “disregarded entity.” A disregarded entity is one that is disregarded as an entity separate from its owner.” https://www.irs.gov/businesses/small-businesses-self-employed/limited-liability-company-possible-repercussions.
[3] “A partnership is the relationship between two or more people to do trade or business. Each person contributes money, property, labor or skill, and shares in the profits and losses of the business.” https://www.irs.gov/businesses/partnerships.