Few events do more to change a person’s course in life than marriage, death or divorce. Issues can arise when one of these events comes up in the middle of a 1031, determining its success or failure. Thankfully, as blessed or as difficult as circumstances surrounding these life changes can be, through careful tax planning, many benefits can still be reaped. As with many challenges in 1031 situations, success is dependent on the “same taxpayer rule” which requires that the taxpayer(s) who sell the relinquished property must be the same taxpayer(s) that buy the replacement property. While this seems straightforward, real life tends to complicate matters. Besides often jointly owning a house, cars and raising children, many married couples also own investment real estate together. If a couple is doing a 1031 exchange and selling a jointly-held property that shows both their names on the title, to comply with the same taxpayer rule, both names would have to be on the title to the replacement property purchased. In this instance, it’s relatively easy to complete a 1031. But what can be done if one spouse purchased the investment property that is now being sold prior to getting married, but now wants the title on the replacement property to be in both of their names? Going from one spouse to both would violate the “same taxpayer” rules (this varies in community property states).
Happily, a solution can be found with some careful pre-exchange or post-exchange tax planning. Under Section 1041, spouses can make unlimited tax-free transfers, allowing them to transfer interests in any property they own to the other. Given this example, the spouse who originally owned the property alone could simply transfer an interest to her spouse, so that they would both be on the title of the property being sold. It’s important to know, however, that in the context of an exchange, the timing of when the transfer takes place may be important. While some tax professionals are comfortable with immediate transfers, others will advise their clients to make any transfers a minimum of one to two years before or after doing a 1031 exchange.
Abraham Miller is quoted as saying “Marriage does not unite two people; it entangles them.” At times, lenders validate this with certain loan requirements. If property that is in one spouse’s name is sold and a loan is needed to purchase the replacement property, the lender may require that both spouses (for qualifying purposes) be on the loan application and deed. Once more, going from one spouse on the relinquished title to both spouses on the replacement would violate the “same taxpayer” rules. In this instance, the solution may be to buy a replacement property that is more expensive than one the one sold. The replacement property can then be purchased in both names, but the ownership interest for each spouse will be different. As long as the original owner’s prorata deed interest equals his or her exchange value, then they are in compliance with the “same taxpayer” rules.
For example, Kelsey owned an investment property before she and Adam were married. She is selling her debt-free property for $900,000; the property that she and Adam would like to buy is worth $1,000,000. All exchange documents will be in Kelsey’s name. At the replacement closing, she would be shown as owning a 90% deed interest with Adam owning the remaining 10% interest. Kelsey’s 90% deed interest equals her $900,000 exchange value from the relinquished sale, and she has complied with the “same taxpayer” rules.
Divorce can also complicate a 1031 that is in process or one that is planned. Spousal property that is transferred within 2 years before, or 1 year after, the date on the divorce certificate is considered a tax-free transfer under Section 1041 with no gift taxes due. Consequently, if an exchange is just about to start or is already in process, it may be best for the transaction to be completed before the divorce is filed. Assuming that the couple co-owns the property in their individual names as tenants-in-common, each party will be viewed as a separate owner and can either complete their own exchange or cash out and pay the tax.
If the divorce paperwork has been filed, then the parties will have to get a judge’s approval to sell or buy property until the final divorce decree is issued by the court. Once the assets have been properly transferred, the party receiving the investment real estate can sell and complete an exchange. So, in summary, if a transaction is already underway or about to begin, it’s important to consider completing the exchange before filing for divorce. If not, it may be best to wait until all property transfers per the court approved settlement agreement have been completed.
In an example, David has agreed that as part of their divorce settlement Ashley will receive the 40 acres of highly appreciated land they bought together. Ashley wants to sell and exchange into income property because she needs the cash flow. In order to preserve the benefits of the 1031, Ashley should wait until the final decree has been issued by the court and David deeds his interest in the property to her before selling and starting the exchange.
There also can be complications and challenges that accompany the death of an exchanger. If an investor in the midst of a 1031 sells the relinquished property but dies before the replacement property is acquired, then the exchange must still be completed, or tax will be due. If the replacement property is not purchased, the sale will be fully taxable. Though the estate will receive a step up in basis to fair market value at the death of the taxpayer, this does not come into play in this type of situation because the property was sold while the investor was still alive. So, if the estate does not complete the exchange, then the sale will be treated as a regular sale of investment property. This means that either the estate will be responsible for paying the resulting tax liability or it will be due on with the decedent’s final return. Both the advantages of the 1031 and the more advantageous step up in basis benefit will be lost.
If the relinquished property that was sold was owned by a husband and wife and either dies before the replacement property is acquired, then, just as in the prior discussion, the estate needs to complete the decedent’s part of the transaction in order to preserve the full exchange benefit. For example, Steve and Beth bought land 40 years ago for $100,000. The property sells for $1,100,000 as part of a 1031 exchange. Five days after the closing, Steve dies. The family promptly establishes legal estate authority per the will. The couple’s son, Christopher, acting as the executor, signs on the estate’s behalf to finish the exchange. This saves the estate (and Beth) from having to pay tax on Steve’s 50% of the gain (or $500,000). Additionally, the basis will be stepped up from the original $100,000 to $600,000 ($550,000 for Steve’s portion and $50,000 for Beth’s original portion), benefiting Beth in the future.
If you are planning on doing a 1031 exchange or are in the middle of one and find yourself in one of the situations above, you should take additional care to preserve the value of your exchange. Be sure to seek guidance from your tax professional. If you have questions, you are welcome to call or email us.
