We have been developing a specialty of helping landlords move their real estate investments from California to metro Phoenix, because the environment is much more landlord friendly here.  I bumped into a fellow who got married after he bought the property he wants to sell using a 1031 Tax Deferred Exchange and he asked me about including his heirs on the title of the replacement property.

This is harder than it sounds if you are doing the transaction as a 1031 tax deferred exchange.

In this blog I will quickly and superficially go over the concepts, try to talk you out of the idea of changing the title in the middle of a 1031 exchange, and then give you different ideas that may allow you to achieve your goal.

The most common question we get about this runs along the lines of, “What if I get remarried, or divorced, on want to change my after-death planning in regard to my income property?”

You can change the title to your property at any time when you are NOT taking advantage of the Section 1031 rules, but it is still important to plan ahead so you should always start with your CPA..

Aligning the title throughout the actual 1031 tax deferred exchange helps avoid complications with documentation and compliance. Even if tax issues are not triggered immediately, inconsistent vesting can delay or invalidate your exchange.  In other words, the IRS can come back later and say you owe taxes, maybe a lot of them.  The tax identity of the owner is more important to the IRS than the specific title or name.  Legal title can change, but the tax identity of the tax payer cannot.

But what if you have already started the exchange process?

In 1031 exchanges, sometimes people want to or need to add or remove children or a spouse to the Replacement Property, or place the property into a trust or some other sort of entity.   While this is easy outside of a 1031 Exchange, during an exchange changes must be done very carefully.  Changes to how the title is held can invalidate the exchange and potentially trigger taxes.

General Guidelines

To ensure the validity of a 1031 exchange, the same taxpayer who sells the relinquished property must also be the taxpayer who acquires the replacement property.

This means the vesting on the replacement property should match the vesting on the relinquished property exactly, based on what is known as the Same Taxpayer Rule.

• If both spouses are on the title to the Relinquished Property, both should be on the Replacement Property.
• If only one person was on the Relinquished Property, ideally only that person should be on the Replacement Property.

The only time it makes sense to change names on title during a 1031 exchange is when a lender requires it.

Sometimes a lender will require both spouses to be on the title in a community property state like Arizona even if only one spouse is applying for the loan.  In community property states, assets acquired during the marriage are considered jointly owned so the lender needs the non-borrowing spouse’s consent to secure the property.

Sometimes a change in the landlord’s situation requires a co signer on the new loan that wasn’t required before.

Almost every time a change in title is successfully done in a case like this, it is because the lender requires it.

Talk to your lender as soon as you consider the sale of the property you want to exchange out of.  Finding out ahead of time about possible titling issues is a really smart move.   Some lenders are more experienced in 1031 exchanges than others, so getting a good lender as part of the planning process is a must.

If the lender you pick requires a change in title as a condition for financing the replacement property, document this requirement carefully to prove the change was for financing purposes and not a ploy to avoid tax liability.

Your lender, your 1031 Exchange Company, and your Title Company (yes plan that part out too) will each have legal council that can help you figure out exactly what you need and what will work for you.  Be specific ahead of time with all parties because laws and terminology vary from state to state.

In other words, work with professionals and make the changes you need to make prior to the exchange, and make absolutely certain you don’t make it look like you made a change to avoid paying taxes.

Here are some ideas you can discuss with them

Change the title ahead of time.  There are a lot of options that can make an exchange easier in the future.

Even in a common law state like Arizona, a disclaimer deed is used to title a property in only one spouses name.  Our title company can explain it and help you with it.

Title your income property in the name of a Revocable Living Trust, because in the future you can change the trust without changing the title of your properties.

What are common exceptions?

Disregarded Entities: The IRS treats certain entities as extensions of the individual taxpayer. These include single-member LLCs, revocable living trusts, Delaware Statutory Trusts (DSTs), and Illinois Land Trusts.  Talk to your CPA ahead of time.

Single-Member LLC: A single-member LLC (taxed as a disregarded entity) can sell or acquire property in an exchange without violating the rule because the individual owner remains the same taxpayer for IRS purposes.  Again, talk to your CPA ahead of time.

Related Party Exchanges: Transfers between related parties (e.g., family members, entities with shared ownership) are permitted under IRC Section 1031(f) but require a mandatory two-year holding period to prevent basis shifting abuses. The holding period ends early if the taxpayer dies or if the property is involuntarily converted.  Talk to your CPA ahead of time.

Partnership Interests: Partnership interests themselves are generally excluded from 1031 exchange treatment under IRC §1031(a)(2)(D). However, strategies like a “drop and swap” (where the partnership distributes property to partners as tenants-in-common before the exchange) are sometimes used to allow individual partners to participate, but these carry risks and require careful planning and professional guidance.  Talk to your CPA ahead of time.

Technically, waiting until after the exchange is completed is allowed, but you should wait until the exchange is “old and cold.” This can mean several years, and even then make sure you consult a professional like a CPA or 1031 specialist.  Laws can and do change over time.  Talk to your CPA ahead of time.

Revocable Living Trust/Illinois Land Trust/DST: Property held by a grantor of a revocable living trust, beneficiary of an Illinois Land Trust, or owner of a DST beneficial interest is generally considered held by the individual taxpayer.  Talk to your estate planning expert ahead of time.

Death of a Taxpayer: If a taxpayer dies during an active 1031 exchange, the estate is allowed to complete the transaction and receive the tax deferral. This prevents the exchange from being invalidated solely due to the taxpayer’s death.

 

How we can help

If you want to move your money from one income property to another, let’s say because a property is fully depreciated, or because you want to move from a landlord hostile location to a landlord friendly location like Phoenix, talk to us right away.   Being proactive will help tremendously, and we can connect you with all the people you will need to successfully make this happen for you BEFORE you start the process, especially if you know a lender will require it.  Make sure you also check in with your CPA or tax professional so that they can make sure that whatever you do is defensible in front of the IRS.  We will guide you to the right people because the tax implications can be severe even if you make an honest mistake.