Can a Co-Inheritor Do a 1031 Exchange?

Published Categorized as Federal Income Tax, Real Estate, Tax
drop and swap taxes real estate

Those who create wealth often accumulate assets to store the value of wealth they create. This includes assets that store value and produce additional income, such as real estate.

In many cases, the wealth creator has put considerable time and effort into building their portfolio of investments. But when they die, those who inherit are not interested in the specific investments.

This may be due to the inheritor being in a different life phase, such as a phase that requires capital instead of income, feeling that the investments are too risky for their risk tolerance, or not performing fittingly for them.

Regardless, the outcome is the same. The inheritor receives an asset that has appreciated significantly in value over time–they hold the property over time as the probate process drags out and then, eventually, the inheritor wants to sell the property.

For real estate investments, this is where the Section 1031 exchange comes in. The Section 1031 exchange can allow the inheritor to avoid having to pay tax on the appreciation during the time they held the property. This is one area where advanced tax planning can be helpful, as a combination of strategies can really produce significant savings (such as investing in real estate using IRAs, and then using 1031 exchanges for non-IRA investments).

The recent IRS Private Letter Ruling 114894-23 addresses this situation and provides an opportunity to consider the rules for inheritors wanting to do a Section 1031 exchange for their inherited property.

Facts & Procedural History

The taxpayer in the PLR was one of several beneficiaries of a testamentary trust established by the decedent’s will. The trust held real property located in State Z, which had been held for investment purposes throughout the trust’s existence. The trust was set to terminate upon the death of the last surviving child of the decedent’s daughters who was living at the decedent’s death (the “Terminating Event”).

Before the Terminating Event, the trustees planned to engage in a 1031 like-kind exchange of the property. However, during negotiations with a potential buyer, the Terminating Event occurred, and the trustees determined that it was no longer feasible for the trust to complete the exchange.

As part of the trust termination plan, the trustees agreed to accommodate beneficiaries interested in completing a 1031 exchange. The taxpayer, along with some other beneficiaries, expressed their desire to do so.

The plan involved distributing tenancy-in-common (“TIC”) interests in the property to single-member LLCs owned by each exchanging beneficiary, subject to a sales contract. The taxpayer planned to have her LLC engage in a 1031 exchange after receiving the TIC interest. The result would be that the taxpayer could essentially trade her interest in the inherited real estate for another property and not pay tax on the appreciation at the time of the exchange.

About 1031 Exchanges

Section 1031 provides a tax deferral tool for real estate investors. It allows taxpayers to postpone paying capital gains taxes on the sale of an investment property by exchanging it for another “like-kind” investment property. This strategy, known as a 1031 exchange or a like-kind exchange, has become a cornerstone of real estate investment planning.

The primary purpose of the 1031 exchange provision is to encourage continued investment in real estate and other productive assets. By allowing investors to defer the recognition of capital gains when exchanging one investment property for another, Section 1031 removes a potential barrier to reinvestment. Without this provision, investors might be reluctant to sell a property due to the immediate tax consequences, even if reinvesting the proceeds could lead to more profitable opportunities.

Moreover, the 1031 exchange rules incentivize investors to keep their properties in good condition and put them to productive use. If an investor were to hold a property indefinitely to avoid paying taxes on the sale, the property could fall into disrepair or become underutilized. By facilitating tax-deferred exchanges, Section 1031 encourages investors to seek out properties that better fit their investment strategies and have the potential for higher returns. This, in turn, can lead to more efficient allocation of resources and stimulate economic activity in the real estate sector.

From the IRS’s perspective, 1031 exchanges do not represent a permanent loss of tax revenue. Instead, they allow for a deferral of tax until the replacement property is sold in a taxable transaction. The IRS will eventually collect the tax on the capital gains, either when the investor ultimately sells the property without conducting a 1031 exchange or upon the investor’s death (unless the property receives a step-up in basis at death).

Many sophisticated real estate investors use 1031 exchanges as a long-term strategy to build wealth while minimizing their tax liabilities. By continuously reinvesting the proceeds from the sale of one property into another through a series of 1031 exchanges, investors can potentially defer capital gains taxes indefinitely. This strategy allows their investments to grow tax-deferred, with taxes being paid only when the investor chooses to cash out or upon their death.

Like-Kind Properties

One of the key requirements for a 1031 exchange is that the relinquished property and the replacement property must be “like-kind.”

The term “like-kind” has a specific meaning in the context of 1031 exchanges. The term “like-kind” refers to the nature or character of the property, rather than its grade or quality. This means that properties do not have to be identical to qualify as like-kind. For example, a single-family rental home could be exchanged for a multi-unit apartment building, a commercial office space, or even raw land, as all of these properties are considered real estate.

Prior to the Tax Cuts and Jobs Act (“TCJA”) of 2017, the like-kind exchange rules were more meaningful, as the rules allowed for exchanges of certain types of personal property, such as vehicles, equipment, and artwork. This required taxpayers to be careful as to how they grouped or defined the relinquished and replacement property as the IRS would frequently audit and make adjustments based on this issue. However, the TCJA narrowed the scope of 1031 exchanges, limiting their application to real property only. This change took effect on January 1, 2018, and as a result, exchanges of personal property no longer qualify for tax deferral under Section 1031. So taxpayers do not have to make this distinction anymore.

Under the current rules, most real estate properties are considered like-kind, regardless of their specific characteristics or use. This broad interpretation of like-kind within the real estate category provides investors with significant flexibility when selecting replacement properties. For instance, an investor can exchange a vacant lot for a shopping center, a warehouse for an apartment complex, or a single-family home for a fractional interest in a large commercial property.

Holding Period Requirement

While the like-kind requirement for real estate is relatively broad, investors must still ensure that they are exchanging property held for investment or used in a trade or business. Properties held primarily for personal use, such as primary residences or vacation homes, do not qualify for 1031 exchange treatment.

The distinction between property held for investment or used in a trade or business usually comes down to the taxpayer’s intent. This is often measured or shown by the taxpayer’s holding period for the property.

This “holding period” requirement is designed to prevent taxpayers from using the 1031 exchange provisions to immediately cash out of an investment without paying taxes. While there is no specific minimum holding period, taxpayers must demonstrate their intent to hold the properties for investment purposes.

This is one of the more challenging aspects of 1031 exchanges. As with the fact pattern in this PLR, taxpayers may invest in a property and then circumstances change and they want to sell the property. This leaves it open for the IRS to come in and question whether the taxpayer really intended to hold the relinquished property as an investment.

Joint Ownership Where Some Want to Exit the Investment

The other challenge for many 1031 exchanges involves multiple owners who wish to part ways, with only one of the partners wanting to do the 1031 exchange.

The rules generally say that all of the joint owners of the relinquished property have to participate in the 1031 exchange. If only a few of the joint owners want to cash out or invest in another property, this can limit the availability of the 1031 exchange.

In situations where multiple owners of an investment property wish to go their separate ways, with some wanting to cash out and others seeking to do a 1031 exchange, a “drop and swap” strategy is often used.

With this approach, the joint ownership is first converted into tenancy-in-common ownership, with each owner receiving an undivided fractional interest in the property. The owners who want to cash out can then sell their interests, while those seeking a 1031 exchange can proceed with the exchange using their separate interests.

This can allow for a 1031 exchange where not all of the investors participate. This can also draw IRS scruitiny–leaving the IRS to argue that the relinquished property was not held for investment but rather, was merely held for sale.

Applying 1031 Exchange Rules to Inherited Investment Property

The PLR addresses a common scenario where multiple beneficiaries inherit investment property through a trust, but not all of them wish to continue holding the property. In this case, the trust held real estate for investment purposes, and upon the trust’s termination, the beneficiaries were faced with two main challenges: the short holding period of the inherited property and the fact that some beneficiaries wanted to cash out while others preferred to conduct a 1031 exchange.

The taxpayer proposed a solution involving a “drop and swap” structure. This approach involves converting the trust’s ownership of the property into TIC interests, which are then distributed to separate single-member LLCs owned by each beneficiary. By doing so, the taxpayer effectively addressed the joint ownership issue, allowing each beneficiary to control their own portion of the inherited property.

However, the primary concern in this case was whether the short holding period of the inherited TIC interest would disqualify the taxpayer from using a 1031 exchange. The IRS agreed with the taxpayer, stating that the trust’s distribution of the TIC interest, subject to the sales contract and as a result of the trust’s involuntary termination, would not preclude the taxpayer from treating the interest as being held for investment under Section 1031.

Several key factors influenced the IRS’s decision in this case. First, the trust had held the property for investment purposes throughout its existence, demonstrating a clear investment intent. Second, the trust’s termination and subsequent distribution of the TIC interests were involuntary, meaning that the beneficiaries did not have control over the timing of the distribution. Finally, the taxpayer expressed a clear intent to hold the replacement property acquired through the 1031 exchange for investment purposes, further supporting the argument that the inherited TIC interest was legitimately held for investment.

The Takeaway

The IRS’s ruling in this PLR helps as it distinguishes between a legitimate 1031 exchange of inherited investment property and a prearranged drop and swap transaction designed to facilitate a cash-out of an investment. The IRS provided a framework for assessing the validity of 1031 exchanges involving inherited investment property.

This PLR is particularly significant because it addresses the drop and swap technique, a strategy that has been commonly used by investors but for which there is little guidance. The IRS’s acknowledgment of the drop and swap structure in this ruling, along with its analysis of the specific facts and circumstances, can be helpful in planning similar transactions in the future.

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