Who can exchange to whom?
There is a bit of confusion surrounding the 1031 tax exchange when the property is owned by more than one individual, specifically around the time they begin considering an exit strategy. The question sometimes arises after the relinquished property has already entered escrow, which poses problems because there isn’t much the parties can do when they’ve gone that far.
Perhaps Uncle Joe wants to take an Alaskan cruise and Aunty Kay must take her annual Vegas trip. They want to cash out, but you prefer to keep the money invested and earning passive income. Because you’re family, of course you want to keep everything copacetic and not start a fight you know won’t end well.
If the property records show that you own the property as individuals, no problem. Each individual owner can go his/her separate way without a backwards glance; those cashing out will pay capital gains taxes (currently federal 15% plus 7% to the State of Hawai`i), keeping the rest for traveling or voice lessons, football tickets or home improvement projects–whatever your souls desire.
But say, for example, an LLC (limited liability company) owns the property and all of the owners want to go their separate ways. How can some exchange while others cash out? The answer is that they can’t until, of course, the LLC is dissolved.
Unless the LLC and the new owners are the same people. Simply put, if the taxpayers don’t change, it’s an allowable exchange. For example, say you have an LLC wherein you and your aunt and uncle are the only members. Your relinquished property is in the LLC’s name and you want to purchase your replacement property as a trust; as long as you, Aunty Kay, and Uncle Joe are the only owners in the new property with the same percentages of ownership, you have an allowable exchange. Once you begin changing either element on the replacement side, you don’t.
There’s also the option known by the IRS as the ‘drop and swap,’ which usually raises a red flag for auditors; this is when the members of an LLC drop the entity just before closing and swap into ownership as tenants in common (TIC). After the sale, the individual members of the TIC are able to exchange into their own individual properties.
Limited partnerships and other like entities have been known to do the drop-and-swap dance from time to time, too, but your tax professional will probably advise against it, even though the exchange companies say they see it all the time. One tax pro told me that switching entities is allowable and can be done as long as a reasonable amount of time has passed between the dropping and swapping. The general consensus is that a year or two should suffice, but trying to get the IRS to define “reasonable amount of time” is near impossible.
Unfortunately, if your property is owned by a corporation you’re in a bit of a pickle. The reason? Corporations can’t be dissolved into individual shareholders before a sale precisely because its entire existence rests on the premise that it’s an individual in itself. In other words, corporations may only exchange into corporations. So what if the same Aunty Kay and Uncle Joe are stock holders with you and your family? Upon the sale of your property, if you chose to cash out instead of exchanging, you are liable for full corporate taxes. Do you have a payroll? Say ‘hello’ to double taxing. And losses can’t be deducted. If there is share distribution, the first $50,000 is taxed at 15% and anything over that gets slapped with a 25% rate. Another tax pro says, “anyone who owns a C-Corp should fire their attorney and accountant.”
In corporations, you’re stuck with the shareholders until that fateful day when you decide to pay all those taxes, which physically hurts the pocketbook. On the bright side, once the taxes are paid, you could always start from scratch with your own pot and begin to build by exchanging up over time, building wealth without the constraints of joint forms of ownership.
Of course, it’s imperative to check with your tax expert about your unique situation, but these guidelines are meant to help you weigh your options. Questions about how much your investment property is worth and how much you might be able to exchange? Email me at firstname.lastname@example.org or call 808-429-1098, and we can discuss your concerns.
Want to talk to my tax guy, Jamie Cottage?
Cottage & Associates, Inc.
Certified Public Accountants
9250 Wilshire Blvd, Suite 220
Beverly Hills, CA 90212