One of the required elements of a successful 1031 tax-deferred exchange is having the same taxpayer that sells the relinquished property purchase the replacement property. This is known as the “same taxpayer” rule. For example, if “Corporation X” sells relinquished property, “Corporation X” must buy the replacement property in order to receive tax deferral treatment.
When spouses are involved in exchange transactions, it is best to take title to the replacement property in the same manner that the relinquished property is held. For example, if one spouse owns the relinquished property as separate property, that spouse should acquire the replacement property as his or her separate property. Similarly, if the relinquished property is owned by both spouses, then both spouses should acquire the replacement property.
Adding a Spouse to Replacement Property
On occasion, however, someone may sell relinquished property and then want or need to add a spouse to the replacement property, for personal reasons or to accommodate a lender requirement. Opinions vary about whether doing so is a problem for an exchange.
In an old Technical Advice Memorandum (TAM 8429004), a married couple holding title as tenants in the entirety transferred relinquished property. The transfer was not a 1031 exchange, but an IRC 1033 exchange that was triggered by an eminent domain action. The replacement property was then acquired solely in the name of the husband. The IRS ruled that because the wife’s name was not on the deed to the replacement property, she should be treated as having gifted her portion of the proceeds to her husband and tax was owed on her 50% portion of the proceeds from the converted property.
Applying this same reasoning to IRC 1031, if one spouse is on title to the relinquished property and the second spouse is added to the replacement property, the first spouse’s exchange value on the replacement property may only be 50% of the value (since the other 50% would be attributable to the added spouse). Because of this, tax advisors often recommend that a married couple jointly holding title to the relinquished property should take title jointly on the replacement property in order to avoid a taxable event.
This Technical Advice Memorandum was issued prior to the enactment of IRC Section 1041. Section 1041 provides that no gain or loss is recognized on the transfer of property between spouses, or incident to a divorce. The legislative history of section 1041 shows that Congress felt that it was inappropriate to tax transfers between spouses because the Internal Revenue Code treats spouses as a single economic unit. Additionally, the House Report states that the intent of IRC 1041 was to make the laws relating to relations between spouses less intrusive.
The reasoning of section 1041 should apply to spouses adding or subtracting a spouse to replacement property in a 1031 exchange. However, in the absence of clear guidance from the IRS, it is always best to check with your tax advisor to determine what is best for your individual exchange transaction.
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