1031 Exchange: The same taxpayer rule

What is the Same Taxpayer Rule in a 1031 Like-Kind Exchange?

In a 1031 exchange, the taxpayer who owns the relinquished property must be the same taxpayer who takes ownership of the replacement property. The guiding principle behind 1031 exchange tax deferral is that the taxpayer has reported all the of their incidents of ownership and provided a continuous taxpayer identity to the IRS therefore, all of their basis will carry over into the new replacement property and can be tracked.
With a 1031 exchange the taxpayer is getting temporary tax deferral, not permanent tax avoidance, and the deferred gain will ultimately be due with a future sale without an exchange. If the taxpayer were to change identities midway through an exchange, there would be no continuity of tax ownership and no reason to allow tax deferral. Exchange regulations are clear that for the exchange to be valid the seller and buyer within an exchange need to have the same tax identity.

Can a taxpayer change ownership structure and still maintain their tax identity? (Answer: yes)

This relates to the tax identity, not the specific name of the title of the property. So, how can a taxpayer hold title that would preserve the tax identity?

• Hold title in 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 beneficiary of an Illinois type land trust
• Hold title as a Tenant in Common (TIC)
• Hold title under a Delaware Statutory Trust (DST)

Holding Title in the Taxpayer’s Own Name

The taxpayer’s own name is the most common form of ownership. This ownership can be as an individual, LLC, SMLLC, partnership, etc. There is always a tax identification number associated with this ownership.

Holding Title as a Single Member LLC, Trustee of a Revocable Living Trust, or TIC

Single member LLCs and Self Declarations of Trust (Living Trust) are known as “tax disregarded entities.” These entities are taxed to the party that is the sole member of the LLC or the grantor/beneficiary of the trust. A TIC is also deemed to be owned by the owner of that Tenant in Common share. The fact that there are other co-owners of the property has no adverse consequences to the taxpayer being the same taxpayer who sold the property individually.

Holding Title under a Delaware Statutory Trust

DSTs are regarded as a trust; however, the owner of a DST share is regarded as owning a beneficial interest in the trust. As such, a person selling as an individual but buying 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

An Illinois Land Trust is like the DST in that the owner of the trust interest is considered to be holding the beneficial interest in the trust that holds title to the property. Since an exchange of a “beneficial interest” was not allowed under Section 1031 in the past, many sellers of property within a land trust faced a lot of uncertainty as to how to proceed. Eventually the IRS issued Private Letter Ruling 92-105 confirming that due to the unique nature of an Illinois Land Trust, the beneficiary causing sale of land trust property would qualify for the benefits of tax deferred real estate exchange.

Your spouse and the same taxpayer rule

Occasionally a single spouse is on title to the relinquished property and the taxpayer would like to add the spouse to the title to the replacement property. This is not encouraged since the other spouse was not the same taxpayer who sold the relinquished property.
When a taxpayer does want to bring the spouse on title, advisors usually suggest waiting until the exchange in question has seasoned for several years.
Sometimes, only one spouse will be on title to the property but lender requirements regarding replacement property financing will require the other spouse to go on title as well. If this is a written request from the lender, rather than the taxpayer’s election, it is unlikely that the IRS would disallow it.

Death of a Taxpayer during a 1031 Exchange

An investor that dies during an exchange (after the sale and before the purchase) needs special treatment from the IRS, considering the fact that a deceased individual and his estate are not the same taxpayer. The IRS does allow the estate to continue the exchange to fruition and receive deferral treatment.
Note: With an unexpected death, a 1031 property (not involved with an exchange) with deferred taxes will receive a “step up” in cost basis that effectively eliminates any previously deferred tax burden to the heirs.

Conclusion

The idea behind like-kind exchange tax deferral is based upon a continuous taxpayer identity. The taxpayer cannot change their identify between the sale and purchase process of the 1031 exchange. This voids the continuity of the taxpayer identity. Keep in mind, there are a wide variety of ownership structures, many of which are disregarded for tax purposes (which is essential), that do allow a taxpayer to hold their relinquished property or purchased property in a different name while keeping the same tax id number and maintaining the same taxpayer identify.