Divesting jointly owned real estate can bring about some complicated ownership issues and tax liabilities, especially if one co-owner wants to do a 1031 exchange to defer capital gains taxes and others want to cash out of their real property holdings.
Exchanges have strict rules that have to be followed to the letter. Joint owners who have the same goals can accomplish an exchange without too much hassle, while joint owners with divergent views face a much more cumbersome journey.
It is possible to do a 1031 exchange on jointly owned property regardless of how the property is titled; however, this type of exchange often involves some strategic advanced planning to ensure a successful exchange. Below we’ll cover a few common co-ownership structures and discuss how they can affect the 1031 exchange process.
1031 Exchanges for Assets Held By LLCs, Multiple Partners and Tenants-in-Common
In a limited liability company where two owners hold title to real property with 50-50 interests, each owner has to mutually agree to relinquish the property and complete a 1031 exchange. That’s because the LLC is the actual owner of the property rather than its individual members, and in order to successfully complete an exchange the owner of the replacement asset has to be the same taxpaying entity as the owner of the relinquished asset, which is the LLC.
If joint owners want to dissolve their partnership and go their separate ways, or one owner wants to continue owning real estate while others want to liquidate and take cash from sale proceeds, that’s fine too – business plans often change. Exchanging is a bit more complex, though.
In this instance, one path to successfully completing a 1031 exchange involves dissolving the LLC into separate partnerships roughly a year prior to selling the jointly held asset. Each partner will receive deed to the property in the form of a distribution from the partnership. The owners will hold the property as tenants in common for a year, and after the 12 months have passed, both partners can safely take their separate paths away from the jointly held asset. Partner 1 is free to roll sale proceeds over into a 1031 exchange because he or she can satisfy the requirement that the asset was held for productive business or trade or as an investment. Partner 2, meanwhile, can cash out and pay any associated capital gains taxes, or roll sale proceeds over into a separate 1031 exchange with similar fractional ownership interests.¹
If there are multiple partners in an asset’s ownership structure, they still can complete a 1031 exchange after divesting the property, but it also involves a lot of advance planning. If one partner wants to walk away, a new partner could acquire his or her ownership interests and the partnership can go on to complete an exchange. Alternatively, the current partnership can complete an exchange, and after a period of time it could buy out the interests of any dissenting partners. Lastly, after successfully completing a 1031 exchange the partnership could reorganize into a tenancy-in-common ownership structure and distribute funds to any dissenting partners on a pro-rata basis.²
In each of these instances, the replacement asset should be held long enough to prove that it was purchased as a rental or investment asset – generally 24 months, although that timeline is not absolutely defined by the Internal Revenue Service.
The Bottom Line
There are many different variations to the exchange strategies mentioned here, and each has the potential to bring about increased tax risk and financial liabilities for co-owners who fail to carefully map out their exchange strategies in advance with experienced 1031 exchange specialists, qualified intermediaries, and financial professionals. Their insight can prove essential to structuring a successful exchange for jointly held real estate.
Sources:
1. IRS Provides Guidance on Using Tenancy-in-Common Interests in 1031 Exchanges, CCIM Institute, https://www.ccim.com/cire-magazine/articles/irs-provides-guidance-using-tenancy-common-interests-1031-exchanges/
2. Section 708 of the Internal Revenue Code, IRS, https://www.irs.gov/pub/irs-drop/rr-99-6.pdf
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.
