On its face, section 1031 appears to be a relatively straightforward law, but as you dig beneath its surface, you’ll find there are many potential issues. That’s why the best advice I can give for dealing with section 1031 is to focus on its central purpose: to allow diligent taxpayers to defer the tax liability incurred in a like-kind exchange. I find that new information about section 1031 is easier to digest when you refer back to this central principle.
An easy way to test this advice is to consider the issue of section 1031 and trusts. It might seem that financial trusts would create plenty of complication when mixed with section 1031. But, in fact, the connection between the two things is much simpler than you might think.
What Is a Trust?
A trust is an entity designed to hold a property for the benefit of a particular person. In a trust, property—whether real or personal—is held legally by one person but owned by another person. Trusts are composed of three distinct parties:
- The trustee: The person who holds title to the property and manages it. The trustee is also occasionally referred to as a fiduciary.
- The beneficiary: The person who actually owns the property and benefits from the trustee’s management.
- The grantor: The person who established the trust.
Trusts confer a number of substantial benefits and can be extremely useful entities in various circumstances. However, not all trusts are identical. There are different types of trusts, and they have different implications for section 1031 exchanges. There are four types of trusts that are pertinent here:
- Grantor trusts, such as a revocable living trust.
- Non-grantor trusts, such as an inter vivos trust or testamentary trust.
- Land trusts, such as an Illinois land trust.
- Delaware statutory trusts (DST).
Trusts may be involved in section 1031 exchanges provided that they satisfy the “same taxpayer” requirement.
How Trusts Partake in Like-Kind Exchanges
One of the core principles guiding like-kind exchanges is the idea that the same taxpayer who sells the relinquished property of an exchange must also acquire the replacement property in that same exchange. There must be a continuity of ownership for a legitimate like-kind exchange to take place. Given this condition, trusts can take part in section 1031 exchanges as long as the same entity that disposed of the relinquished property also obtains the replacement property.
For grantor trusts, the trust is not considered a “separate entity” (meaning that it is an independent legal entity and must have its own tax return) for federal tax purposes, so the grantor has the option to hold both the relinquished property and replacement property in the trust, or he or she may also hold only one in the trust and another outside of it. The grantor will not have to file a separate tax return for the trust, so the same basic taxpayer requirement is met.
Non-grantor trusts, on the other hand, are considered separate entities. So a non-grantor trust must acquire the replacement property in situations in which the non-grantor trust already holds title to the relinquished property. Again, this is the way that the same taxpayer requirement is observed.
With land trusts and DSTs, the situation is a bit different. The IRS has ruled that an interest in land held by either a land trust or DST may constitute a legitimate real property interest in the context of a section 1031 exchange. So, you may either dispose of such an interest or acquire such an interest as part of a 1031 transaction.
However, prior to undertaking such a transaction, be sure that the land trust or DST is not arranged in a similar manner to a partnership, otherwise, 1031 treatment may not be available. For instance, if the trust has multiple beneficiaries, pay close attention to the provisions of the trust: If the provisions seem to indicate an arrangement that is akin to a partnership, then you may lose 1031 eligibility.
These points discussed above provide a good introduction to trusts and 1031 exchanges, but there are certainly more points you should be aware of as a prudent investor, so it’s often best to seek the advice of an expert. CWS Capital Partners can provide useful counsel in this area.
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