Husband and wife or domestic partner acquire an investment property in a 1031 exchange and in a divorce decree the partner receives the property. Years later, the partner wishes to sell the property. Does a 1031 exchange make sense? It depends upon the tax consequence and whether the partner’s intent is to replace with an investment property.
1031 Exchange
A 1031 exchange allows the titleholder to defer the federal and state capital gain and recaptured depreciation tax when “like-kind” property of equal or greater value is replaced within 180 calendar days post-closing on the old property. There are many rules to follow, with the first to engage a Qualified Intermediary (QI) to accommodate the exchange. The role of the QI is to provide documentation in accordance with Internal Revenue Code (IRC) Section 1031 for the titleholder and buyer to sign. The QI holds the exchange funds in a safe, liquid escrow account under the titleholder’s tax identification number for use towards acquiring the replacement property. If the titleholder accesses or touches the funds, the 1031 exchange is over.
Divorce
In a divorce, the adjusted basis of the titleholder is the basis of the transferor’s as stated in IRC Section 1041. For example, while A and B were married they initiated a 1031 exchange, acquiring a vacation rental property. A and B divorce with B receiving the rental property as part of the settlement. B wants to sell the rental property and replace with another rental property in a different state. B should visit with their CPA to understand the tax consequences. In a two property 1031 exchange for a relinquished property with a sale price less than $500,000, the QI fee ranges from $750 to $1,200. If the QI fee is substantially less than the tax due, then most likely B should initiate a 1031 exchange.
So what happens if a couple who recently acquired an investment rental property in a 1031 exchange and one of the two wants to occupy as their primary residence in less than the two year holding period? Given the hold time is outside the “safe harbor” of two years, the courts apply a subjective test as to the taxpayer’s intent at the time the replacement property was acquired.
Tax attorney David Shechtman of Drinker, Biddle & Reath provided the following review.
“In Reesink v. Comm’r, T.C. Memo 2012-118, the Tax Court approved an exchange where the taxpayers converted their replacement property into a personal residence some eight months after acquisition. In that case, the taxpayers demonstrated a clear investment intent at the time of acquisition and that they converted the property to a personal residence only because of unforeseen circumstances (financial setbacks which forced them to sell their more expensive residence and “downsize” into the replacement property). If the husband and wife can demonstrate investment intent and that conversion is occurring because of unforeseen circumstances, they should be okay.
Unforeseen Circumstances
Unforeseen circumstances are when the taxpayer fails to meet the original intent by reason of a change in the location of employment, health, or, to the extent provided in the Regulations. This also applies to a “mixed use” property where the taxpayer utilizes a part of the property as their primary residence and the other portion as an investment property, such as a Bed and Breakfast, farm, or a duplex. The portion used as the primary residence is eligible for the Section 121 exclusion while the portion held as an investment property is eligible for Section 1031 tax deferral. To qualify for the Section 121 exclusion, the taxpayer must hold the principal residence for periods totaling two years or more over a five year period. The exclusion is available once every two years. If the taxpayer fails to meet the two year ownership and use requirements, then a prorated fraction of the exclusion may be taken given the unforeseen circumstances.
Learn more about 1031 exchange steps to consider.
1031 Exchange Rules
Real property can be exchanged for any real property. Examples of real property exchange include a vacation rental property for land, mineral interests for a single family residential rental and a thirty year leasehold interest for a triple net lease or tenant in common property.
The taxpayer who sells is the taxpayer who buys. If a husband and wife are titleholders on the property, then they need to be the titleholders on the replacement property. If a single member limited liability company (SMLLC) is the titleholder, then either the SMLLC or the member can be the replacement property titleholder. If a limited liability company has two members and one wants to cash out while the other member wants to defer the gain, then as soon as possible, the two member limited liability company should be dissolved. A new deed should be recorded reflecting the names of the two members as tenants in common. The Purchase and Sale Agreement should then reflect the names of the two members rather than the limited liability company.
Post-closing on the old property, the replacement property must be identified, preferably to the QI, no later than 11:59 PM on the 45th calendar day. The replacement property must be acquired no later than the 180th calendar day post-closing.
The replacement property must have a sales price equal to or greater than the relinquished property sales price. All the net equity from the sale along with debt equal to the debt retired must be used to acquire the replacement property. Any cash or debt not re-established is considered boot and taxable. Additional cash offsets debt, but additional debt does not offset cash.
To learn “Ten Reasons Why a 1031 Exchange Makes Sense,” click here for a free PDF.
