The 1031 Exchange Same Taxpayer Rule: Complete Guide for Real Estate Investors

If you own business or investment property through a corporation, partnership, or trust, it may be possible to perform a 1031 like-kind exchange, but only if you adhere to the 1031 exchange same taxpayer rule, which requires the taxpayer to remain intact through the exchange process.

Understanding 1031 exchange requirements for different ownership structures

A Section 1031 like-kind exchange allows real estate investors to defer capital gains taxes on the sale of business or investment property if they use the proceeds to purchase a like-kind property. Section 1031 has long been a method by which U.S. taxpayers and real estate investors can build wealth through property ownership. However, many income-producing properties are not owned by individuals. What happens in those cases?

1031 exchanges can be performed with a variety of ownership structures -individuals, LLCs, corporations, trusts, partnerships, and other entities. The structure under which your relinquished property was purchased determines how your replacement property must be acquired in order to achieve capital gains tax deferral. At the heart of the issue is something called the 1031 same taxpayer rule. The same taxpayer rule states that the taxpayer that owned the relinquished property must be the same taxpayer to acquire the replacement property. Here’s how this rule works and how to avoid 1031 exchange mistakes.

What is the Section 1031 same taxpayer rule?

IRC Section 1031 outlines the rules for like-kind real estate exchanges, including the kinds of properties that qualify as like-kind and restrictions for related-party 1031 exchanges and other disallowed transactions. Section 1031 specifically grants the ability to defer capital gains taxes via a like-kind exchange to a “taxpayer,” which is important to note, as a “taxpayer” is not the same thing as a “person.” Just as an individual can pay taxes, so can a corporation or other legal entity.

Whether you own property individually, with a partner, or via a legal entity like an LLC or trust, the taxpayer that sells property in the exchange must be the same taxpayer that buys property in the exchange. Otherwise, you won’t be eligible for 1031 tax deferral.

Why does the 1031 same taxpayer rule exist?

The purpose of Section 1031 is to ensure continuity in investment: you have your capital invested in a property, and instead of taking that money out after the sale, you’re investing in another property, thereby continuing your investment. Because you’re merely exchanging one property for another, Section 1031 allows you to defer taxes until you eventually cash out of the investment, allowing you to reinvest more of the equity built up in the initial property.

But if the taxpayers are different, then this is a new investment, not a continuation of the original one. The same taxpayer rule prevents individuals from attempting to circumvent capital gains taxes by transferring property to others without reporting it as a sale.

For example, imagine you own a property individually. You then exchange it for a new property, but the new property is acquired through a partnership that includes you and a close friend. This partnership then performs a second exchange, with the replacement property acquired solely by your friend. You would then have given your friend a property without paying the requisite taxes. This isn’t what 1031 is designed for, which is why this action would be disallowed.

The flip side is that your initial choice of structure is very important. If you purchase a property as an individual, you have to keep exchanging as an individual. If you want to switch to ownership via a corporation (for example, if you wish to work with other investors to purchase a larger property), you’ll first need to cash out and pay capital gains taxes.

The same is true if you purchase a property as part of a corporation or partnership. You can’t just sell the property and exchange your individual proceeds. The entity must remain intact, except for in a few key instances that we’ll describe below.

What happens if I violate the 1031 same taxpayer rule?

If you violate the same taxpayer rule, the exchange will be ruled invalid, and you will be required to pay capital gains and any other taxes you were hoping to defer. If you completed the acquisition of the replacement property, your sales proceeds would likely already have been used to acquire it, meaning this tax burden could force you to sell the replacement property before you were ready, or sell other assets to come up with the cash to pay the taxes.

In other words, the same taxpayer rule does not prevent you from carrying out the transactions of your exchange. Instead, it is ruled upon later, when you file your taxes. The result could be a much larger tax burden than you anticipated, making this rule an important one to understand and follow properly. This is why it is imperative to enlist the services of a reputable and knowledgeable Qualified Intermediary (QI), such as JTC.

Exceptions to the 1031 exchange same taxpayer rule

Disregarded entities

An exception to the same taxpayer rule is a disregarded entity for tax purposes, which is a business entity that has a sole member and is not taxed separately. For example, if you are the sole member of an LLC and do not file a separate tax return for this entity, then you can perform an exchange where a property you own individually is sold and a replacement property is acquired by the LLC. You can also perform an exchange from one LLC to another, provided you are the sole member of both LLCs so that any gains/losses are reported on your individual tax return.

Trusts and estates

Another example of a disregarded entity is a revocable living trust for 1031 exchanges. If you are the individual grantor of a revocable living trust, then you can sell an individually-held property and acquire the replacement property through the trust (or vice versa) without violating the same taxpayer rule because the IRS views the trust and the grantor as the same taxpayer.

The same is not necessarily true of an irrevocable trust, which is generally taxed separately. States have varying rules regarding the assumption of revocability, so whether or not your particular trust will qualify depends largely on where and how it was created.

Marital transfers

1031 exchanges involving non-community property can be complicated when the spouses are separate taxpayers. It can be advantageous to add the other spouse to the title of the relinquished property, but this should be done far in advance of sale, not during the exchange process.

To go the other direction, from a jointly-held property to one held only by one spouse, has been previously disallowed through a technical advice memorandum (TAM 8429004), which held that it amounted to one spouse gifting their share to the other spouse. This is further complicated by revisions to Section 1041, which allows for non-recognition of gain on the transfer of property between spouses.

The IRS has not clarified how the same taxpayer rule could be affected by Section 1041, making competent legal advice all the more valuable before embarking on a 1031 exchange involving spouses, as interpretation of the law could change at any time.

Can I dissolve a partnership or LLC during a 1031 exchange?

As the American Bar Association explains, “Multi-member LLCs and partnerships are not disregarded for purposes of an exchange. Thus, if a partnership owns real estate and wants to exchange it is the partnership or LLC which must exchange not the partners.”

In other words, if the partnership holds the relinquished property, it must be the partnership that acquires the replacement property, not any new entity or the members individually. However, this doesn’t mean that there are no options for changing ownership structure.

Drop and Swap 1031 exchange

It’s possible to perform what is known as a Drop and Swap 1031 exchange transaction to change one or more partners’ relationships to a Tenancy-in-Common (TIC). Once a partner is a tenant-in-common, they can perform an exchange by selling their interest and acquiring a replacement property, or sell and cash out if they wish.

Swap and Drop 1031 exchange

Another method is the Swap and Drop, where the exchange is performed first, and the partnership dissolved later. Imagine you have an LLC with three members that holds one property. The LLC could exchange into three separate properties. Then, after a holding period, the LLC can be dissolved with each member taking control of one property.

Drop & Swap transactions are complicated, and their treatment will vary by state. The important thing to know is that it is possible to exit a partnership and continue tax deferral, with the right planning and tax professional guidance.

What happens if I will my 1031 exchange property to my kids?

Many real estate investors invest because they hope to leave as much as possible behind for their heirs. Some even manage to continue tax deferral through 1031 exchanges until they die, at which point their heirs receive a step up in basis for the property. The basis will then be set when the individual inherited the property, not when the original property was purchased. In this way, it’s possible to avoid capital gains taxes by holding properties until death, a strategy known as “swap till you drop.”

But what if your heirs, after inheriting your property, want to continue deferring taxes through subsequent exchanges? Are they unable to perform 1031 exchanges with your property because the taxpayer will be different?

It is possible to perform like-kind exchanges with inherited property without violating the same taxpayer rule. Even if you pass while an exchange is in progress, it may be possible for your heirs to begin their own tax deferral strategies by exchanging into new properties. For more on 1031 exchange estate planning and preserving tax deferral for future generations, read our guide to 1031 and estate planning.

The best way to avoid violating Section 1031 exchange rules

It’s important to understand the same taxpayer rule, which is one of many 1031 exchange rules an IRS requirements that need to be followed in order to successfully defer taxes. But as we’ve seen, there are exceptions and ways to structure an exchange to avoid breaking the rules. You just need the right professional guidance.

The critical role of a qualified intermediary (QI)

The most important thing you can do to set yourself up for exchange success is to get help early. Talk with your tax and legal advisors well in advance of your property sale, and retain a Qualified Intermediary (QI) before you begin your exchange.

Every exchange needs a QI to hold sales proceeds during the exchange. There are few rules governing who can be a QI, but that doesn’t mean you should work with just anyone. There have been cases where QIs went bankrupt, misused exchange funds, or were unable to transfer funds in time for the exchanger to meet the 180-day deadline. And if you’re performing a complicated exchange that requires specific actions to avoid violating rules like the same taxpayer rule, you need a QI with experience.

Why choose JTC for your 1031 exchange

JTC has worked with exchangers of all sizes, from Fortune 500 companies to first-time 1031 exchangers just starting their tax deferral journeys. Every client receives the same access to our team’s 1031 expertise and our secure online portal that offers 24/7 access to exchange information. We do our utmost to protect the security of your funds while adhering to 1031 regulations so you can get the most out of your exchange and build wealth for the future.

Learn about JTC’s 1031 exchange services