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Vesting Issues and 1031 Exchanges
A basic requirement of a 1031 exchange is that investors take title to a replacement property in the same way that it was held by the relinquished property (i.e. the same name on the tax return). For example, if you held title to relinquished property as Fred Jones, you could not take title to the replacement property as Jones Investment.
The only time the IRS allows for an investor to effect a 1031 tax deferred exchange with out the replacement and the relinquished property holding title in the same name is if the title of either property is held in what is known as a “disregarded entity”. A disregarded entity is one that does not file a separate tax return and where the Principal of that “entity” is filing the tax return that will include that “disregarded entity”. The list includes a Revocable Living Trust, an Illinois Type Land Trust, and a Single Member LLC. There are brief descriptions of each below.
The Revocable Living Trust does not file an income tax return. All of the rents, dividends, interest, expenses, etc. arising from assets owned by the living trust are reported in an investor's personal tax return. So, if Fred Jones owned the relinquished property in the name of the "Jones Revocable Living Trust," he can sell it, do an exchange, and buy the replacement property as "Fred Jones" because the same tax return owned the relinquished property.
An Illinois Type Land Trust is a type of trust where the property is held in the name of the trust, but multiple owners of the trust are considered the true owners -- the trust does not file a tax return. If there are three owners, then three tax returns for 1031 purposes. If Fred is one of the owners, he can sell his share and buy replacement property as "Fred Jones," again because it is all the same tax return. Illinois Type Land Trusts do not protect the owners from personal liability and are not commonly used.
A Single Member LLC does protect an investor from personal liability, but the tax return is filed as separate from the individual members. When you file a tax return for an LLC with only one owner, the IRS will send it back and tell you to report the income and expenses on your own individual tax return. If Fred Jones sells his relinquished property, he can buy the replacement property as "Jones Investments, LLC" if he is the only member, because again, it is all the same taxpayer.
It is important that an investor discuss any investment decision thoroughly, with their tax and legal professionals regarding vesting issues when doing 1031 exchanges.
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