Same Taxpayer Requirements for Spouses
An IRC §1031 tax deferred exchange allows owners of business or investment property to exchange into other business or investment property and defer paying capital gains tax. One of the basic rules of a 1031 exchange requires, with limited exceptions, the taxpayer selling the relinquished property to be the same taxpayer purchasing the replacement property. Married couples can face some challenges to the “same taxpayer” rule in non-community property states where husband and wife are deemed separate taxpayers.
If only one of the spouses is on the title to the relinquished property then that spouse, as exchanger, should be on the title to the replacement property for an interest equivalent to the exchange value. If property is held by a husband and wife jointly on the title when they sell the relinquished property then both of the spouses can 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 situation where only one spouse is on title, the other spouse can be added to the title of the relinquished property before the 1031 exchange but the timing is very important. Some tax professionals will advise their clients not to make any transfers for a minimum of one to two years before or after doing a 1031 exchange in order to mitigate any “held for investment” exposure.
Alternatively, 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 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.
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.
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 your exchange transaction. Property owners must consult their tax and/or legal advisors for this information. Our role is limited to serving as qualified intermediary to facilitate your exchange. © 2021 Legal 1031 Exchange Services, LLC. All rights reserved.