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Avoiding One of the Most Common Mistakes in a 1031 Exchange

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.

avoid this 1031 mistake in 2019

Avoid Making this 1031 Exchange Mistake in 2019

avoid this 1031 mistake in 2019A 1031 exchange is a powerful vehicle to build wealth by permitting taxpayers to defer capital gains, and depreciation recapture, through a properly executed transaction. But the rules governing exchanges are a “safe harbor,” meaning that the failure to comply exactly with these technical rules will violate the exchange and force the taxpayer to recognize and pay tax on the gain she was attempting to defer. And doing so years after the exchange, for example when an IRS examiner disallows the transaction due to a technical violation of the rules, could add penalties and interest to the pain of having to recognize (and pay tax on) the gain.

One of the biggest reasons for unintentionally violating these rules, relates to the date by which the taxpayer must actually complete the purchase of the replacement property. A quick example will help.

Example: Frank owns a rental property with 8 units. He sells the rental property on November 15, 2018, and properly executes 1031 paperwork and instructs his settlement agent to transmit the proceeds to a Qualified Intermediary, like e1031xchange. Frank then buys another like-kind property and closes on it on February 1, 2019.

Under the IRS rules, there are two deadlines to be aware of. First, within 45 days of the sale (which happened on November 15) he must identify the property which will be acquired, and inform the qualified intermediary with a list of possible acquisitions (typically the list is limited to 3 properties, although there are other ways to identify which provide more options, and we will address that in future articles). Second, Frank must close on the replacement property within the time allocated by the IRS. And here is where it gets complicated.

Generally, the rule for closing on the replacement property is that it must close no later than 180 days from the date of the sale of the relinquished property. In the example above, the relinquished property closed on November 15, 2018, so 180 days from that date is May 14, 2019. But be careful, the IRS regulations have a minefield here. The exchange is violated if the replacement property (the property Frank is buying as a replacement for the property he sold)

“is received after the earlier of the date that is 180 days after the date on which the taxpayer transfers the relinquished property, or the due date (determined with regard to extensions) for the transferor’s federal income tax return for the year in which the transfer of the relinquished property occurs” (emphasis added to bolded words)

Huh? The regulation accelerates the date by which the exchange must be completed to the earlier of the following two dates: (a) 180 days after sale (e.g. May 14, 2019), and (b) the date that Frank’s 2018 tax return is due, which is April 15, 2019! Suppose Frank is quite efficient, and is ready to file on January 1, 2019 and in fact does file on that date. Now he cannot change the due date by filing an extension. In such a case, Frank will have inadvertently blown the 1031 exchange if he closes on the replacement property after he files his return. Sometimes, efficiency just does not pay!

The easy work-around: Frank’s CPA must avoid filing the 2018 return until the replacement property is acquired. In this example, Frank had until May 14, 2019 to close on the replacement property, if he uses the full 180 days. So if he goes right up to the wire, and does not close until that date, his CPA should pay the tax he owes, and file for an extension for the 2018 tax return prior to the normal April 15 filing deadline in order to avoid tainting the exchange by not closing in a timely fashion.