Exchanging Properties Held in Trust: Navigating the Pitfalls
To accomplish a successful tax-deferred exchange, the same taxpayer that transferred the relinquished property must acquire the replacement property.1 On the surface this “same taxpayer” requirement seems straightforward, but care must be taken when title to an asset is held in a trust.
When property is held in a trust, another potential hurdle comes from the statute itself. Certificates of trust or beneficial interests in trusts are specifically excluded from non-recognition treatment under §1031.2 This exclusion is an extension of the similar prohibition against the exchange of stocks, bonds or notes.3 Thus, before entering into an exchange a determination must be made as to the nature of the interest in question. Fortunately, through various IRS rulings and decisions, there is some clarity regarding the application of the statute to how trusts are used in the real world.
Grantor TrustsGrantor trusts have become increasingly common for estate planning purposes. In a typical grantor trust the grantor retains control over the property held in the trust. The trust is not considered as a separate entity for tax purposes. Thus, any income is reported on the grantor’s individual tax return.
Since the trust is disregarded for tax purposes, the exchange properties will meet the same taxpayer requirement, regardless of whether they are titled in the taxpayer’s individual name or in the name of the trust. For example, the taxpayer may hold the relinquished property as an individual, but acquire the replacement property in a revocable living trust. In some instances a husband and wife will want to hold title to a property in their separate trusts. Care should be taken to ensure that the proper interests end up in the right trusts.
Land TrustsLand Trusts present a unique problem, especially in Illinois. The beneficial interest in an Illinois land trust is personal property under state law. Despite those factors, the IRS will treat that interest as like-kind for the purpose of an exchange. The trustee is merely an agent to hold and transfer title, not a trustee who actively works to protect and conserve property for a beneficiary.4 Similar reasoning has been applied to allow the exchange of properties held in revocable trusts, as noted above.
Several states have arrangements similar to an Illinois land trust, notably Florida, California, Hawaii, Indiana, North Dakota, and Virginia. The holding applies to an interest in a similar arrangement created under the laws of any state where the trustee holds title to real property, but the beneficiary has the obligation to pay any taxes and liabilities of the property, as well as the exclusive right to direct the trustee in dealing with the title, control the management of the property, and receive the earnings from the property.
However, the holding in Rev.Rul 92-105 is not applicable if such an arrangement creates an entity (such as a partnership). For all practical purposes that means a land trust arrangement will meet the same taxpayer requirement only if there is a single beneficiary.
Delaware Statutory Trusts (DST)Under Delaware law, a DST is an entity that is recognized as separate from its owners. The beneficial owners are entitled to the same limitation on personal liability that is extended to stockholders of Delaware corporations. A DST is an entity for federal tax purposes.
Because a DST is an entity separate from its owner, a determination must be made as to whether it is a trust or a business entity for federal tax purposes. If the DST is a trust, then the individual owners can exchange their interests in a §1031 exchange.5
The trust agreement provided that the trustee’s activities were limited to the collection and distribution of income. For example, the trustee could not exchange for other property, renegotiate the terms of the debt used to acquire the property, or renegotiate leases with the tenant. Because the DST’s trustee had none of the powers which evidenced an intent to carry on a profit making business, the DST in question was classified as a trust. If the requirements of the revenue ruling are followed, an interest in a DST will be considered an interest in real property and may be transferred as part of a tax-deferred exchange. Just as with a land trust, a DST must avoid partnership attributes.6
Non-Grantor TrustsUnlike a grantor trust, in a non-grantor trust the grantor has given up all right, title, and interest in the trust assets. Only the trustee has the power to revoke or terminate the trust. The trust must obtain its own tax identification number and file annual returns to report its income.
Since it is a separate taxpayer, if a non-grantor trust owns the relinquished property, it must also acquire the replacement property. The trust beneficiaries cannot acquire the replacement property in their individual names.
ConclusionDespite the potential negative effects of the statutory prohibition against exchanging trust interests and the application of the same taxpayer requirement, it is possible to do a §1031 exchange of properties held in trust. Grantor trusts are not separate taxpayers, so property can be exchanged in or out of a grantor trust without jeopardizing the tax-deferred status. Arrangements such as land trusts and DSTs will generally enjoy the same treatment as a grantor trust, but must be careful to avoid partnership attributes when there are multiple beneficiaries. Finally, a non-grantor trust is a separate tax entity, so any exchange transaction must be done in the name of the trust.
For more information, please contact your local First American Exchange office.
1. T.J. Starker v. United States, 602 F.2d 1341, 1351 (9th Cir. 1979).
2. 26 USC 1031(a)(2)(E).
3. 26 USC 1031(a)(2)(B) and (C).
4. Rev. Rul. 92-105, 1992-491 I.R.B. 4.
5. The IRS addressed this issue in Rev. Rul. 2004-86.
6. See also: Rev. Proc. 2002-22.