Real Estate Investment: Part III – Structuring the 1031 Exchange
This is the third and final part of our discussion regarding the use of a 1031 Exchange to defer tax on real estate investments. Used correctly, real estate investors might even defer tax indefinitely—or at least during their lifetimes.
Part I was an overview of the whole process. In Part II, the focus was on the use of a qualified intermediary. Here we will review restrictions regarding the identity of the seller and purchaser. Spoiler alert – with very few exceptions, the identity has to be the same.
Naturally, there are many important aspects of a 1031 Exchange, all of which are deserving of attention. We are choosing, however, to focus on matching the seller and buyer because that issue is particularly relevant to investors.
It is very common for investors to join forces with other parties in joint ventures. So, for example, Joe Investor has accrued some equity in his investment property—we will call it “Property A”—and he would like to use the money to purchase a more valuable property, which we will call “Property B.” However, Joe Investor either does not have enough cash to purchase Property B on his own, or would rather share the risk with someone else. Certainly, this is a very typical scenario.
Under normal circumstances, Joe Investor would go out and find a Jane Investor to go in with him on the purchase of Property B. Joe and Jane would likely form an LLC or a land trust to hold Property B, each having an ownership interest corresponding with the amount of his/her capital contribution. Here is the kicker.
If Joe Investor sells Property A, which was titled in his name, and buys Property B with a company or land trust, he destroys the 1031 Exchange and loses the ability to defer tax.
It does not matter that Joe used the money from Property A to buy Property B – even if he did properly use a qualified intermediary (as discussed in Part II). The tax payer that sells Property A has to be the same taxpayer that buys Property B. For investors, this is a rather unfortunate restriction and an important pitfall of which to be aware.
There is an exception, though it would not help Joe Investor in our example. If Joe held title to Property A as a single-member LLC—where Joe was the single member—then he would be allowed to discard the LLC and purchase Property B in his personal name without losing the tax deferral benefits. That exception does not provide Joe the ability to purchase Property B with a co-investor, though. To do that, we will need an additional step.
The code does not prohibit Joe Investor from selling Property A, purchasing Property B in his own name, and then transferring Property B to an LLC or trust, which is owned jointly with Jane Investor.
Now, if Joe and Jane do the exchange this way, Jane will be exposed until Property B is transferred to the LLC/trust. Joe could double-cross Jane.1
If Joe and Jane trust each other explicitly, that risk might be acceptable. As an attorney, I never ceased to be amazed at how many of these deals go wrong. I probably have a skewed view of the business world because only the transactions that go wrong are brought to my office. Nonetheless, that is just not smart business. The solution is for Joe and Jane to execute a joint venture agreement stipulating that, while Joe will be the titleholder, temporarily, Jane has an equitable interest in Property B.
Now, I know what you are thinking. What if both Joe and Jane want to use proceeds from the sale of their respective Property As to purchase Property B? Well . . . every problem has a solution. Call my office.
1There are mechanisms in the law that might protect Jane; however, she would be forced to spend money on litigation with no guarantee of prevailing. Not ideal.