Understanding Tax Ownership for Individual
Those who are familiar with Internal Revenue Code Section 1031 tax-deferred exchanges believe that the vesting of the property sold by the taxpayer must match the vesting of the replacement property acquired in the trade. In simpler terms, if title to the property relinquished in the exchange is in a corporation, then the same corporation needs to purchase the replacement property. Although the preceding statement stands right in multiple cases, it merely serves as a guideline for an adequately structured exchange. The essential element in a valid 1031 exchange is to ensure that the “tax owner” of the relinquished property acquires the tax ownership of replacement property within the time period dictated by IRS. There are various ways to procure tax ownership of property that can include the use of certain business entities or trusts which are disregarded for federal income tax purposes.
For better understanding let’s familiarize ourselves with (i) federal tax ownership, (ii) state law ownership, and (iii) vesting. In the case when all three indicators of ownership match up, example – “Mark Smith” holds title to an investment property as an individual. However, Mark might not own the property for which he holds title under federal or state tax law. Many states accept nominee arrangements under which Mark can hold title for the benefit of an actual owner of the property. In such a case Mark will be the record title holder, but not the state law owner or the tax owner of the property. When the property is sold the gains will not go to Mark but to the actual property holder.
Understanding Tax Ownership for Limited Liability Company
If a property is held in by a limited liability company the tax ownership depends on how the LLC is characterized for federal income tax purposes. If the company has chosen to be taxed as a corporation, then the company will hold the tax ownership. If there is more than one person in the limited liability company and it has not selected to be considered as a corporation for tax purposes, then it is managed as a partnership for federal income tax purposes making the company tax owner of the property. If, however, Mark is the sole member of the LLC and the company has not chosen to be considered as a corporation for federal tax purposes, then Mark will be the owner of the property for federal income tax purposes. As per federal tax law, a single member limited liability company is a “disregarded entity” and the assets are reviewed as being owned by the sole member of the company.
Revocable trusts are another sector where tax ownership, state ownership, and vesting may differ. During the lifetime of a person who establishes a revocable trust (a Grantor) and during the time he or she maintains the right to cancel the trust, federal law considers the Grantor as the tax owner of assets preserved in the trust. So, as the Grantor, Mark becomes the tax owner of assets held in the revocable trust, however, the trust is treated as an entity under state law and for purposes of vesting and ownership of trust property. Thus, Mark can sell property owned by his revocable trust as per a 1031 exchange and acquire replacement property in his own name.
In most of the preceding examples, a valid 1031 Exchange was achieved even in situations where the vesting of the relinquished property did not match the vesting of the replacement property. Thus, the idea that vesting of the relinquished property and the replacement property must be the same is not an essential requirement. We only need to ensure that the tax owner of the relinquished property takes tax ownership of the replacement property.