Dividing real estate during a divorce can be difficult -- doubly so with assets acquired through a 1031 exchange.
IRS Code Section 1031 allows taxpayers to defer capital gains taxes on the sale of investment properties, provided they roll those proceeds over into a like-kind replacement asset. Although divorce can complicate a 1031 exchange, spouses can still reap many of the benefits of an exchange through careful tax planning.
Below we’ll cover some of the most salient points about 1031 exchanges and divorce. While tangled and intricate, there still can be some positive benefits for taxpayers who find themselves trying to split real property assets in a divorce.
1031 Exchanges and Titling
In many instances, real estate is the single-largest jointly owned asset in a marriage. Couples who acquired investment properties during their marriage face some additional hurdles when trying to split assets, but they can be overcome with careful execution from qualified tax professionals.
Titling is one of the main challenges associated with divvying real property acquired in a 1031 exchange. In order to comply with IRS regulations, the same taxpaying entity must be listed on the title of the replacement asset. So a couple that acquired a vacation rental during their marriage can’t simply sell the asset and complete another exchange without holding joint title -- not an ideal situation for couples trying to separate their lives and key financial assets.
However, under section 1041 of the IRS Code, one spouse can make a tax-free transfer of their ownership interests in real property to the other. So in theory, one spouse can transfer his or her shares, and the sole owner can then divest the asset and complete a 1031 exchange, if desired, to defer capital gains. Many tax professionals find this issue a little murky, with very little direct guidance from the IRS on the matter. Proceed down this path under the guidance of legal and financial advisors with direct experience in separating 1031 exchange properties in a divorce to avoid a disqualified exchange.¹
1031 Exchange and Adjusted Basis
If one spouse does transfer their interests in an investment property to the other, they do so at an adjusted basis under IRC Section 1041.
This carryover basis rule applies regardless of whether there’s gain or loss in the value of the asset. For example, a couple purchases a vacation rental for $100,000. During divorce proceedings, the husband transfers the property to the wife for $180,000, the property’s current fair market value. The wife’s adjusted basis in the asset remains $100,000.²
1031 Exchange: Occupying an Investment Property
In some instances, couples acquire investment properties through a 1031 exchange, and one party wants to occupy the residence after splitting up. Tax professionals counsel a two-year minimum hold time for properties acquired during a 1031 exchange to satisfy the requirement that the property was purchased primarily for business use or as an investment. If that safe-harbor hold time has not been met, an audit may disqualify the previous 1031 exchange and leave the ex-spouses with a capital gains obligation.³
The Bottom Line
Divorce proceedings can be quite complicated, especially when it comes to equitable division of investment real estate. Be sure to seek counsel from qualified legal and tax professionals if you have real property assets acquired through a 1031 exchange while married to get a clearer understanding on how to proceed with splitting those assets and avoid disqualifying your exchange.
1. Same Taxpayer Requirements for Spouses, Legal 1031, https://legal1031.com/1031-exchange-resources/same-taxpayer-requirements-for-spouses/
2. Insight: Basis of Property Transferred Between Spouses Incident to a Divorce, ClientWhys, https://www.taxcpe.com/blogs/news/insight-basis-of-property-transferred-between-spouses-incident-to-a-divorce
3. 1031 Exchange and Divorce, Atlas 1031 Exchange, https://atlas1031.com/blog/1031-exchange-and-divorce/
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.