1031 Exchange Tips

One of the basic requirements of a 1031 exchange is you have to take title to the new property in the same manner that you held title to the old property.

The IRS means the same tax identification number or social security number by "same manner." This means that if Sue owned the purple duplex she sold in her individual name, she can not have her corporation take title to her new property because she has a social security number and her corporation has its own tax identification number and files a separate tax return.

While this concept seems simple enough, it is probably one of the most problematic areas of 1031 law. The reason for many is that they own property in partnerships, corporations and limited liability companies (LLCs).

Let's say Fred owns a one-third interest in the FGH Partnership. The partnership owns a building which it is selling for $300,000. Can Fred take his share ($100,000) and exchange in a building in his name only? No -- because the partnership is the tax return that owned the old property, not Fred's individual income tax return. Only the partnership may do the exchange.

What happens if Fred's partners, George and Howie, don't want to do an exchange -- they just want their share of the cash and are willing to pay the tax. In this situation, Fred will be forced to take his share of the cash and pay tax, too.

A common attempted solution I see a lot (especially if attorneys are involved in the transaction), is to dissolve the partnership and distribute the property to the partners, followed almost immediately by a sale of the property. In other words, Fred, George and Howie would each give back their ownership in the partnership. In return they would each receive a deed for an undivided, one-third interest in the property. Now when they sell the property, there are three sellers (Fred, George and Howie) instead of just one (the partnership), and in theory, Fred is free to do an exchange with his one-third.

There is a big problem with this "so-called solution," however, because Fred will have held the deed to his share of the property in his name for a short period of time. Remember -- to do a 1031 exchange you have to hold the property as an investment, not for resale. As a general rule, the difference between held for investment and held for resale is a year and a day. Fred's share of the property was in his name for only a short period of time, perhaps only hours, and the IRS will disallow his exchange if they audit him, because he only held the property for a short time. Therefore, he only held it for resale. In other words, he sold it shortly after he received it, and the time that he owned his partnership interest will not "tack on" to his direct ownership of his undivided interest in the property.

On the other hand, what if George and Howie also want to do 1031 exchanges, but none of the three want to be partners any longer -- they each want to go their own way? Now things are more flexible.

We structure this by having Fred buy Property #1 (for $100,000). Likewise, George finds Property #2 and Howie finds Property #3 (each also for $100,000). As soon as the partnership sells the Old Property (for $300,000), it acquires Properties #1, #2 and #3 (each for $100,000) as its replacement. They've satisfied their exchange because we have one seller and one buyer (the partnership) and they've satisfied the equal-or-up rule.

We still have to worry about the holding period requirement, so the partnership needs to retain ownership of the three new properties for a year and a day. Once the year and a day mile post has passed, the partnership can then dissolve and distribute the three properties to the three former partners. So, Fred, George and Howie would each return their partnership interest in exchange for the deed to their property -- Fred would return his one-third partnership interest and receive the deed to Property #1. Likewise for George and Howie.