Taxpayer Continuity in 1031 Exchanges: Meeting the Same Taxpayer Requirement

What Is the 1031 Exchange Same Taxpayer Requirement?

The 1031 exchange same taxpayer rule is an implicit requirement that is not directly named in the tax regulations. It requires that the taxable party or entity relinquishing one property is the same as the taxable party or entity that takes possession of the replacement property. This keeps one party or entity from passing the deferred tax burden of the exchange on to another party or entity.

The core justification for tax deferral in a 1031 exchange is that the taxpayer has reported all the incidences of ownership and that the taxpayer’s basis will carry over into the new replacement property. If the relinquished and replacement properties were owned by different taxpayers, that would eliminate the purpose of the tax deferment for the relinquished property.

Exchange regulations require that the same taxpayer must transfer the relinquished property and receive the transfer of the replacement property. This applies both to individual and collective ownership, such as through partnerships or corporations, although there are some exceptions related to changes to an entity’s structure that do not result in changes to the underlying ownership.

The same taxpayer rule applies to the tax identity associated with ownership rather than a specific title or name. The legal title may change, but the tax identity of the taxpayer cannot. The tax identity must be maintained from the relinquished property ownership to the replacement property ownership. For example, the Social Security number or federal tax identification number (FEIN or EIN) used by the selling and buying entities should be the same for both properties.

A Social Security number would typically be used for a single individual’s ownership, including ownership under tax-disregarded entities discussed below in more detail. A FEIN would typically be used for a business or entity ownership consisting of more than one person or more than one entity, such as a multi-member limited liability company or partnership.

Maintaining Tax Identity Continuity Through Changes in Title

Since the taxpaying identity is what must remain consistent across the exchange, there are multiple ways a taxpayer can hold title without breaking continuity. Examples of ways a taxpayer can hold title without breaking continuity include:

• Hold title in the taxpayer’s own name
• Hold title under a single-member limited liability company (LLC)
• Hold title as the trustee of a revocable living trust
• Hold title as a tenant in common (TIC)
• Hold title as a beneficiary of an Illinois-type land trust
• Hold title under a Delaware Statutory Trust (DST) (approved by the IRS in Revenue Procedure 2004-86)

Holding Title in the Taxpayer’s Own Name

The most common form of ownership uses the taxpayer’s own name. However, that does not mean the title has to be held individually, and ownership can be as an LLC, partnership, or similar entity. There is always a tax identification number associated with this ownership.

Holding Title as a Tax-Disregarded Entity or Tenant in Common

Single-member LLCs and self-declarations of trust (living trusts) are known as tax-disregarded entities. Under such an arrangement, the taxed party is the sole member of the LLC or the grantor/beneficiary of the trust. For tax purposes, a TIC is considered owned by the owner of the tenant in common share. The existence of co-owners for the property does not impact the requirement that the taxpayer be the same taxpayer who sold a property individually.

Holding Title Under a Delaware Statutory Trust

While a DST is regarded the same as a trust, the owner of a DST share is regarded as owning a beneficial interest in the trust. As such, a party that relinquishes a property as an individual but buys replacement property through a DST interest is still treated as the same taxpayer, assuming the beneficial interest is held in the same individual taxpayer’s name. In 2004, the IRS issued a ruling confirming that the use of a DST for the purchase of replacement property was permissible with certain restrictions.

Holding Title as Beneficiary of an Illinois-Type Land Trust

Similar to a DST, the owner of a trust interest in an Illinois land trust is considered to be holding a beneficial interest in the trust that holds title to the property. In the past, taxpayers could not use a 1031 exchange to exchange a beneficial interest. This left uncertainty around the sale of property within an Illinois land trust. However, IRS Private Letter Ruling 92-105 confirmed that a beneficiary causing the sale of Illinois land trust property qualifies for a real estate exchange and is not subject to the beneficial interest prohibition.

The Same Taxpayer Rule and Spouses

Sometimes, only one spouse is named as the title holder to a relinquished property. While an exchange could seem like the right time to place both spouses on the property, this could violate the requirement that the tax identity remains the same on both the relinquished and the replacement property. The generally accepted approach for adding a spouse as a title holder for the replacement property is to wait several years after the exchange is completed.

However, owners may not always have the option of waiting. An example would be when there is financing connected to the replacement property — such as when the value of the replacement property is greater than that of the relinquished property. In such a case, the lender may require that the spouse’s name be added to the title of the replacement property. The taxpayer should seek a written request from the lender detailing the need to add the spouse’s name to the replacement property.

Since the addition to the title is at the lender’s request rather than the taxpayer’s election, it is unlikely to draw objection from the IRS. For added safety, a taxpayer can also have a document drawn up that confirms their spouse is holding the interest “in trust” on behalf of the original spouse. There is also an exception for adding the name of a spouse to the replacement property title when the sale is in a community property state.

The Same Taxpayer Rule in Community Property States

In community property states, spouses own all property jointly, regardless of whose name is on the title. This allows for an exception to the 1031 exchange requirement that only a spouse named on the relinquished property title can be named on the replacement property title. This is because, effectively, the title is considered to be held in the name of both spouses when only one spouse is explicitly named. However, even exceptions have exceptions, and some real estate, such as that received explicitly as a gift or inheritance to only one spouse, is not considered jointly owned.

Current community property states include:

• Arizona
• California
• Idaho
• Louisiana
• Nevada
• New Mexico
• Texas
• Washington
• Wisconsin

What If a Taxpayer Dies During a 1031 Exchange?

If a taxpayer dies during a 1031 exchange, the regulations permit the estate to complete the exchange transaction and receive the deferral. For this rule to apply, the property to be sold must have already been relinquished, and the exchange process must be underway. However, it is not necessary for the replacement property to have been purchased prior to the passing of the taxpayer. While a deceased taxpayer and their estate are not the same tax entity, the regulations permit this exception to prevent an unexpected death from unnecessarily burdening a taxpayer’s estate.

Clarifying Continuity for a Trouble-Free 1031 Exchange

The central tenant of like-kind exchanges is continuity. The reasoning for permitting a tax deferral in a 1031 exchange is that the taxpayer has received no taxable benefit from the exchange. Continuity also requires that the taxpayer relinquishing a property be unchanged from the taxpayer acquiring the replacement property. If the tax identity associated with the relinquished property differs from that associated with the replacement property, it introduces the possibility of someone realizing a tax benefit to which they are not entitled.

Even if there is no actual malfeasance, such a variation could draw unwanted attention from the IRS and cost taxpayers both time and money to resolve the issue. However, various types of property-holding arrangements, many of which are disregarded for tax purposes, allow a taxpayer to hold relinquished property in a different name while still meeting the same taxpayer requirement.