If you are conducting a Section 1031 Exchange, “what’s in a name” can be the difference between a successful exchange and one that will fail on its face. This provision, called the Identity of Taxpayer Rule, requires that the same person or entity that sold the old or Relinquished Property be the same one that acquires the new or Replacement Property.
On the surface, this seems pretty easy to comply with, however, what if the Relinquished Property is titled to a husband and wife and they desire to acquire the new property in their revocable trust or a single member limited liability company. Since the IRS is tracking the taxpayer identification number in each real estate transaction, it will be clear that the two numbers do not match and therefore the ownership interest has changed from the old property to the new property and the exchange will fail on its face.
There’s a couple of ways to remedy this situation and preserve the tax deferral that is provided under Section 1031. The logical approach is to simply acquire the Replacement Property in the exact same format of the Relinquished Property; husband and wife sell, husband and wife buy. If they want to acquire the new property in their revocable trust or LLC, then prior to sale, the title must be changed to record the property in that manner. This can layer on the protection needed but it will also add recording and legal expenses.
A second option is to acquire the new property in equal interests in new trusts or LLC’s; one for the husband and one for the wife. In this manner, the taxpayer identification numbers are preserved and will match for exchange purposes. After a two year period of seasoning, the interests could be merged without affecting the Section 1031 protections.
In the current financing environment, many lenders have no interest in lending to trusts or to limited liability companies. If the Replacement Property will require financing, understanding the lender requirements before sale is essential to properly titling the Relinquished Property; so that the lender will be interested in providing the new financing necessary on the Replacement Property. It may be necessary to preserve the ownership in the name of husband and wife for financing reasons and for tax deferral.
Don’t let the fact that the IRS accepts “disregarded entities” lull you into thinking that the bank will accept them or that your state will either! New Hampshire has recently asserted that any change in name (except property going into a revocable trust) will trigger state capital gains tax. This issue will likely be litigated, but in the meantime, be careful.