Navigating the same-taxpayer rule is crucial in a 1031 exchange. This rule dictates that the taxpayer who sells a property must be the same taxpayer who buys the replacement property. Let’s dive into what this means and why it matters.

What is Beneficial Ownership?

Beneficial ownership refers to an individual who enjoys the benefits of owning a property, even if the title is in another name, such as an LLC. This differs from legal ownership, although often, the legal and beneficial owners are the same. 

Beneficial ownership is essential for the taxpayer to qualify for exchange treatment on their property transactions in a 1031 exchange. Understanding this distinction is important as it presents opportunities to take advantage of alternative property types and transaction structures.

Defining the Taxpayer

The term “taxpayer” describes the individual or entity filing a tax return related to the property being sold. This can be an individual or an entity like an LLC. 

Each taxpayer is assigned a unique identification number (SSN for individuals, EIN for entities). The IRS uses this Tax ID to track ownership, not the name on the deed.

Sometimes you will hear a taxpayer referred to as the “exchangor” in conversations related to taxpayers who are selling and purchasing property in the exchange. 

The Same-Taxpayer Rule Explained

The same-taxpayer rule requires that the taxpayer who sells the property must be the same as the one who buys the replacement property. This means the Tax ID number on both sides of the exchange must match. For instance, if John Smith sells a property, John Smith’s SSN must be used to purchase the replacement property, even if the deed is owned by an LLC in which John is the sole member and is considered “disregarded for tax purposes.”  (see next section)  

Disregarded Entities

In most cases, the name of the owner on the deed is consistent with the name as it appears on the tax return. However, for many reasons, an individual or entity may choose to hold title in a name that does not match the name of the underlying taxpayer on the IRS records. This other, distinct (“Subsequent’) name or entity on the deed, if done correctly under IRS attribution or disregarded entity rules, could be disregarded for tax purposes. These subsequent names or entities are called “Disregarded Entities.” 

What this means is that the person associated with the underlying Tax ID number is the beneficial owner and, therefore, the responsible taxpayer, not the named owner on the deed. The entities may have different names on the deed and the IRS records, but they are essentially the same taxpayer because they have the same underlying Tax ID. In a 1031 exchange, what is important is that the underlying Tax ID is the same, not the names themselves. While title is held in the name of a disregarded entity for ownership’s sake, the taxes for ownership of the property would roll up and be filed under the name of the individual or parent entity. 

For example, if John Smith is listed on the deed and his SSN 123-45-6789 is the taxpayer who files an annual return, then John Smith’s SSN must buy the replacement property. The deed could reflect John Smith or ABC, LLC, by naming John Smith the Sole Member (as an example). Both John Smith as an individual and John Smith as the Sole Member of the disregarded entity, ABC, LLC, roll up to the SSN 123-45-6789 for tax filing purposes.

The exchangor should check with their CPA, Tax Advisor, and/or Legal Advisor to verify if any LLC used to hold title to a property being sold or purchased in an exchange qualifies as disregarded for tax purposes.

Adding Spouses or New Partners

When acquiring a replacement property, adding spouses or new partners in a Tenant-in-Common (TIC) structure is possible. If a new party was not on the deed of the property being sold, they are considered a non-exchanging taxpayer. Only the value being purchased by the exchanging taxpayer is eligible for a 1031 exchange. To fully defer all capital gains tax, the ownership percentage of the exchanging party must be sufficient to offset all of what the exchanger sold to fully defer.

Creating New Entities for Purchase

Creating new entities to purchase a replacement property can be tricky. One critical factor is adhering to the same-taxpayer rule. Here are some examples to clarify:

• Example 1:  John Smith owns a property. That property is in the name of a single member, disregarded entity: ABC, LLC. Here, John is the underlying taxpayer. When John purchases the property, he elects to purchase the property in a brand new single-member disregarded entity: XYZ, LLC. This works because both entities are disregarded to John as the underlying taxpayer identification number (SSN 123-45-6789). In other words, on both sides of the exchange, sale, and purchase, the taxpayer is the same. 
• Example 2: John Smith owns a property to be sold/relinquished as an individual using his individual  SSN. That property is in John’s name as the underlying taxpayer (either in his name). When John purchases the replacement property, he elects to purchase it through a brand new entity: QRS, LLC. This entity has multiple members and, therefore, cannot be disregarded for tax purposes. This does not work under the same taxpayer rule of a 1031 exchange because the IRS views this new entity as its own unique taxpayer. In other words, on both sides of the exchange, sale, and purchase, the taxpayer is not the same. 
• Example 3: John Smith and Jane Smith hold title to property together as husband and wife under their individual names. They would like to purchase their replacement property using an LLC for liability purposes. In this circumstance, how John and Jane approach this should be determined by the state the property is located in and the advice of the taxpayer’s legal or tax advisor.
  • In some states, commonly known as “community property states” (Louisiana, Texas, New Mexico, Arizona, California, Nevada, Washington, Idaho, and Wisconsin), certain tax and legal advisors may rely on Revenue Procedure 2002-69 in which the IRS states that LLCs that are created and solely owned by spouses as community property may be considered disregarded for tax purposes. 
  • In non-community property states, John and Jane may still acquire property under disregarded LLCs. However, most tax and legal advisors recommend creating two separate LLCs, one for each spouse, and holding title as Tenants-in-common under these two LLCs. Of course, this comes with additional costs associated with maintaining multiple LLCs.  

Alternative Sale Structures That Enable Same-Taxpayer Compliance

Drop and Swap

In a 1031 exchange, the “drop and swap” strategy allows an entity holding both legal and beneficial ownership to transfer interests to its members before selling the property. This ensures each member can perform individual exchanges while complying with the same-taxpayer rule. Here’s a streamlined overview:

1. Ownership Transfer (Drop): The entity transfers ownership interests to individual members before the property sale, typically using a quitclaim deed. This transfer must occur before the sale closure to ensure compliance with IRS regulations.  It is critical to speak with a tax or legal advisor regarding the timing and method of this transfer.  The IRS has not provided clear guidance as to when and how this “Drop”  can and should be done so as not to count as a taxable event in itself.  Additionally, some industry professionals theorize that this action can cause the sale from the individuals to not qualify for a 1031 exchange on the basis that the property was acquired from the entity by the individuals solely as a property held for sale.  There are also concerns about whether this will be viewed as a stepped transaction, related party considerations, concerns about whether this affects investment intent, holding periods to show investment intent and more. Careful consideration should be taken here especially. It is very important to consult with your tax and legal advisors for any Drop & Swaps.
2. Entity Dissolution: Dissolving the entity in conjunction with the dropdown can simplify the process, as it allows the property to be recorded under the new individual owners. This step is usually coordinated with legal advisors to ensure proper execution.
3. Individual Sales: After the ownership transfer, each member can sell their interest separately. This may (if done correctly and in compliance; please see list of caveats and concerns above)  allow them to perform individual 1031 exchanges on their share of the property, maintaining the same taxpayer (based on their Tax ID) on both sides of the exchange. The sale contract is updated to reflect each individual’s defined interest in the property.

It’s crucial to consult legal and tax advisors to navigate the timing, structure, and legal requirements of a drop and swap effectively. This process involves complex legal and timing issues, including ensuring that the new deeds and revised sale contracts are correctly documented and recorded.

Selling 100% Membership Interests

When an Exchangor sells a 100% membership interest in an LLC, and they are the sole member, the sale conveys both the beneficial and legal interest in the underlying property. This structure allows the entity holding the title to remain the same taxpayer throughout the exchange.

Acquiring 100% of a membership interest in an LLC as part of a 1031 exchange can provide strategic benefits, particularly in avoiding transfer taxes. Many jurisdictions do not assess a transfer tax on the sale of an existing entity that owns real estate, offering potential significant savings. This approach is advantageous as the IRS treats the acquisition of a sole membership interest in an LLC that owns the replacement property as if the taxpayer received title to the property directly.

It is important to note that certain State and County governments are becoming aware that this transfer process is occurring   and accordingly, have been implementing ways to recognize these types of transfers and ways to claw back the taxes that would have been assessed on the transfer.  

In this scenario, the Exchangor effectively maintains the same taxpayer status (based on their Tax ID), ensuring compliance with the same-taxpayer rule. This structure simplifies the exchange process by keeping the taxpayer consistent on both sides of the transaction, thus adhering to IRS requirements.

It’s important to consult with legal and tax advisors to navigate the complexities of selling 100% membership interests. These professionals can provide guidance on timing, structure, and compliance, ensuring the transaction maximizes benefits and meets all regulatory standards.

Exploring Alternative Properties

The IRS allows for various “alternative properties” in a 1031 exchange. These options allow clients to purchase certain fractional interests in properties that are often managed by an entity ownership structure. Many types of ownership structures may qualify as interests in real estate and still satisfy the same taxpayer rule.

These options include:

• Delaware Statutory Trusts (DSTs): A Delaware Statutory Trust (DST) is a type of business trust established under the laws of the state of Delaware in the United States. It is a tax-efficient investment vehicle that allows multiple investors to pool their funds to purchase and hold a fractional beneficial ownership interest in the underlying real estate asset(s) owned by the trust. The DST holds title to the property and provides investors with a passive beneficial ownership interest, typically with the ability to receive a share of the rental income and capital appreciation. If done correctly, the interests in DSTs can be exchangeable under Section 1031.  However, please check with a legal or tax advisor to see if the DST was structured properly.  This can be a complex, detailed analysis needing specialized knowledge and experience. The use of a DST allows investors to invest in real estate without management responsibilities while potentially receiving the benefits of real estate ownership.
• TIC Interests in Syndicated Portfolios: Investors become passive limited partners in larger investments, such as shopping centers or medical facilities. Examples include large shopping centers, medical facilities, CVS, Walgreens, etc. The liquidity here ranges from sponsor to sponsor. 
• Mineral Rights and Solar Farms: Investors can receive working interests in mineral assets or own land used for solar power generation. Like DSTs, mineral, oil, and gas interests are subject to specialized rules and case law, both at the Federal and State levels. So please consult a tax and legal advisor familiar with 1031 exchanges and with the mineral, oil, and gas interests in the states being considered. 

These structures involve detailed and complex requirements that will need review, guidance, and advice from legal and tax advisors.

Conclusion

Understanding and adhering to the same-taxpayer rule is vital for a successful 1031 exchange. By ensuring the taxpayer’s identity remains consistent throughout the transaction and exploring alternative property structures, investors can navigate the complexities of 1031 exchanges effectively. For personalized guidance, always consult with qualified intermediaries and legal advisors.