For an exchange to satisfy IRC §1031, the taxpayer that will hold the title to the Replacement Property must be the same taxpayer that held title to the Relinquished Property. However, business considerations, liability issues, and lender requirements may make it difficult for the Exchanger to keep the same vesting on the Replacement Property. Exchangers must anticipate these vesting issues as part of their advanced planning for the exchange.
There are some exceptions to this rule when dealing with entities that are disregarded for federal income tax purposes. For example, the following changes in vesting usually do not destroy the integrity of the exchange:
- The Exchanger’s revocable living trust or other grantor trust may acquire Replacement Property in the name of the Exchanger individually, as long as the trust entity is disregarded for Federal tax purposes. Rev. Rul. 2004-86.
- The Exchanger’s estate may complete the exchange after the Exchanger dies following the close of the sale of Relinquished Property. Rev. Rul. 64-161.
- The Exchanger may sell Relinquished Property held individually and acquire Replacement Property titled in a single-member LLC or acquire multiple Replacement Properties in different single-member LLCs as long as the Exchanger is the sole member and the single member LLCs are treated as disregarded entities. PLR 200732012.
- A married couple may exchange Relinquished Property held individually as community property for Replacement Property titled in a two-member LLC in which the married couple’s ownership is community property, but only in community property states and only if they treat the LLC as a disregarded entity. Rev. Proc. 2002-69 as amended by Rev. Rul. 2013-17.
- A corporation that merges out of existence in a tax-free reorganization after the disposition of the Relinquished Property may complete the exchange and acquire the Replacement Property as the new corporate entity. TAM 9252001, PLR 200151017.
- An Illinois land trust is a disregarded entity for IRC §1031 purposes, so an Illinois land trust beneficiary may exchange his beneficial interest in Relinquished Property held by the trust for Replacement Property vested in the beneficiary individually, or in a different Illinois land trust, as long as the Exchanger is the beneficiary. Rev. Rul. 92-105.
Adding a party to vesting, such as when the Relinquished Property is owned by one spouse and the Replacement Property will be acquired by both spouses, could result in partial recognition of gain by the spouse on title to the Relinquished Property. Divesting Relinquished Property held in one entity, such as a corporation, partnership, or multi-member LLC and acquiring the Replacement Property in a different corporation, partnership, or multi-member LLC, or in the shareholders, partners or members individually, will disqualify the exchange because the exchange is being completed by a different taxpayer than the one starting the exchange. However, conversion of a general partnership to an LP or an LLC during the Exchange Period will not disqualify the exchange. PLR 99935065.
To avoid disqualifying the exchange, the Exchanger should not make any changes in the vesting of the Relinquished or Replacement Properties prior to or during the exchange. Exchangers are cautioned to consult with their tax or legal advisors regarding how their vesting issues will impact the structure of their exchange before they transfer the Relinquished Property. Proper planning and negotiation can make the difference between a successful exchange and a taxable problem.