Even the most attentive taxpayer can invalidate a 1031 exchange by — unintentionally — violating the “same taxpayer” rule. While simple in concept, a few examples show how mistakes can be made.
Let’s start with the basic rule first. The “taxpayer” looking to defer recognition of taxes using an exchange must be the “same” both with respect to the relinquished property (the real estate sold) and the replacement property (the real estate bought):
Bob Smith owns a condominium that he has been renting out for many years. He sells the condo, opening an exchange, and then two months later closes on a two-family house that he intends to also use as an investment property. Bob closes title on the new property in his name also.
In this simple example, it’s easy to see how we have the “same taxpayer” on both sides of the exchange. Bob Smith was the seller, and on the new property, Bob Smith was the buyer. Now let’s change the facts:
Instead of closing in Bob’s name on the purchase, Bob decides to acquire the new property in the name of an entity that he controls, “Bob Smith, LLC.”
Now it gets a little trickier. The issue above is whether Bob Smith, LLC is a disregarded entity for tax purposes of Bob Smith (the individual). Only Bob’s tax adviser can say for sure, but if Bob Smith, LLC is a single member LLC of which Bob is the sole member, and on his taxes this LLC is treated as a disregarded entity (among other factors it uses the same taxpayer identification number as Bob Smith), then this scenario would not violate the same taxpayer rule, and is permissible. Let’s change the scenario again:
This time, Bob decides to acquire the new property in the name of Bob Smith and his spouse. The spouse was not on the title of relinquished property (the condominium he sold).
This is a common situation that many taxpayers ask about. Acquiring the replacement property in the name of Bob Smith and Mary Smith, without further language in the deed, would in most states presume that Bob and Mary will hold title as husband and wife (if they are in fact married at the time of the purchase) and could potentially violate the same taxpayer rule. Most tax advisers recommend against this, and instead, advise waiting a reasonable amount of time after the purchase before adding Mary Smith to the title (with a simple deed transfer). Alternatively, if Mary Smith needs to be on title for other reasons, for example where her income is needed in the financing and the bank wants her on, then a safer option is to convey title on replacement to “Bob Smith and Mary Smith as tenants in common with each having 50%,” or the equivalent designation under applicable state law. In that case, Bob and Mary override the marital presumption and make clear in the deed that they are tenants in common. As long as 50% of the price of the replacement property is greater or equal to the price of the relinquished property, then this structure should avoid problems with violating the same taxpayer rule. Of course, with respect to all tax matters, a client must consult their tax adviser with respect to their specific situation.