|
Narrow
Deviation Allowed
in
1031 title holding requirement
One of the critical
requirements for
a 1031 exchange is the same taxpayer must
hold title to both the Old and New Properties in the
exchange. While the exact amount of time these properties
must be held is not defined by the IRS, it is clear
that it has to be the same taxpayer, and both properties
must be held for investment.
 |
by
Author Gary Gorman
Founding Partner,
1031 Exchange Experts, LLC |
|
If Fred and Sue, for example, own an
apartment building they are selling as joint tenants,
and buy a replacement property for their exchange as
joint tenants, then clearly the exchange involved the
same taxpayers since Fred and Sue were on title for
both the Old and New Properties. But what if Fred and
Sue wish to protect themselves by putting the New Property
into an LLC as soon as they acquire it? Most attorneys
would say that was a smart business decision and quickly
set up the LLC for them.
The problem is when the attorney transfers
the New Property into the LLC, he has just changed
the taxpayer, because an LLC with more than one member
files a tax return. This would obviously have a different
tax identification number than Fred or Sue’s.
Typically, the attorney’s justification for restructuring
ownership of the property in this way, is Fred and
Sue still control the property, just in a different
legal entity. They would think that any violation of
the 1031 rules would be a mere “foot fault,” and
would certainly not cause their exchange to be disallowed.
Unfortunately the attorney is wrong, and what he’s
just done could toast the exchange.
Don’t get me wrong, I am not
criticizing the attorney. After all, he’s on
the frontlines trying to protect his clients from dangers
much more real then the perceived threat from the IRS
if the exchange isn’t handled correctly. It’s
just that the threat is more real than they believe
it is. The IRS has just released a Private Letter Ruling
which illustrates my point.
In PLR 200651030, the taxpayer was
a Trust set up to handle the real estate portion of
an estate of a gentleman that died many years ago.
Under the laws of the state where the trust was set
up, it was due to expire shortly. The beneficiaries
of the Trust were his heirs (actually the heirs of
his heirs). What the attorneys for the Trust proposed
was to set up an LLC where the members were the same
beneficiaries with essentially the same interest as
they held in the trust. Upon the expiration of the
Trust, the assets will be transferred from the trust
to the LLC.
This ruling became an issue under Section
1031 because of the Trusts many properties. Two were
under contract to sell and exchange soon after the
scheduled transfer to the LLC. Since the Trust and
the LLC will have different tax identification numbers,
they wanted assurance that the IRS would not disallow
those exchanges.
The IRS allowed their plan because
the beneficiaries would have the same ownership interest
in the LLC as they had in the Trust, and because the
beneficiaries had no control over the termination of
the trust – the date of which was set more than
20 years ago. It was also helpful that the trust has
a history of doing 1031 exchange and the managerial
and operational structure of all the properties will
carry over to the LLC. All of which helped to give
the IRS comfort that this was not a scheme designed
by the Trust attorneys to get around the ownership
requirements of Section 1031.
For those of you reading this article
who customarily advise clients on structuring real
estate transactions involving 1031 exchanges, the important
point is that the taxpayer had no control over the
transaction. The Trust was scheduled to terminate by
point of law. The implication is obvious: if you have
control over a transaction which results in the change
of taxpayers (i.e. change of tax identification numbers),
the IRS could view your transaction as a violation
of the same taxpayer rule.
|
