When a 1031 exchange is conducted, there is an assumption that the deferred capital gains tax and depreciation recapture will be paid when the deferment ends, unless there is a step-up to market value in the owner’s estate. Paying those taxes depends on having a clear record of an asset’s ownership—the owner of the relinquished property and of the replacement property must be the same. This far-reaching and seemingly common-sense principle is sometimes challenging to maintain. Community property laws as a whole can complicate the ownership of your 1031 exchange property.
The Confusing Combination of 1031 Exchange and Community Property
There are only nine states with community property laws—Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin—but they make up a significant part of the U.S. economy. Therefore, community property issues can frequently be faced in 1031 exchanges, which are subject to state laws. In addition, Alaska has opt-in community property laws, and, in the laws of Tennessee and Puerto Rico, there are community property elements.
Additionally, the specifics of community property laws vary in each of these jurisdictions, but they all regulate the division of property between spouses. Generally, that is property acquired during a marriage, as well as each spouse’s income and debts in that time. It does not affect property that a spouse owned before marriage or debt acquired before marriage. Gifts or inheritances to one spouse alone are also not counted as community property.
In a community property state, if a spouse relinquishes a property that he or she owns exclusively, there is a risk that the IRS will challenge the exchange if the other spouse is added to the title of the replacement property right away. The addition of the other spouse’s name to the title could be seen as gifting, which would invalidate the exchange as being not held for investment. The situation could arise in which the lender providing the financing for the replacement property requires that the other spouse’s name be on the replacement property’s title.
After the two-year customary holding period for a 1031 exchange property, the couple may decide to add the other spouse’s name to the title and hope not to attract the attention of the IRS. If the other spouse’s name is not on title to that property at the time of the owner’s death, however, the property will not be stepped up to market value in the estate and the surviving spouse will have to pay capital gains on the inheritance.
Removing a spouse’s name from a title can have tax repercussions, too. In the case of divorce, the laws of a community property state may interfere with an agreement worked out in an uncontested divorce. Former spouses who co-own a property that was used in a 1031 exchange are not required to exchange or sell the property together. One may opt to receive cash and pay the taxes on their portion of the property, while the other spouse uses their share in an exchange, if they choose. This can be carried out within the two-year holding period, as divorce is considered by the IRS an unforeseen circumstance.
Other Community Property and Ownership Issues
Community property issues are often quite complex in their details, especially when part of divorces cases. In addition, there are factors besides marital status, particularly related to funding and taxes, that may affect the ownership structure of an asset and require special handling in community property states.
At CWS Capital Partners, we are a fully integrated multifamily real estate investment management firm that offers everything from due diligence and multifamily real estate valuation to transaction support and property management. We specialize in assisting our clients with 1031 exchanges, acquisitions, repositioning, and development. We also own and manage luxury multifamily investment communities in major markets around the country and employ a team of experts who can help you hone your investment strategy.
For more articles like this one, check out our investment strategy blog posts.
Please contact us to learn more about investing with CWS Capital Partners, or view our current offering by completing our self-certification form for accredited or qualified investors.
The information provided here is for your general informational purposes only. It should not be considered a recommendation or personalized advisory advice. CWS has made this third party information available from authors it believes are knowledgeable and reliable resources. However, its accuracy or completeness cannot be guaranteed and sentiment may change due to legal or economic conditions.
All investments involve risk including the possible loss of principal. You should familiarize yourself with all risks associated with any investment product before investing.
Advisory services are provided by CWS Capital Partners LLC, a registered investment advisor.
Securities offered by CWS Capital Partners LLC are through an affiliated entity, CWS Investments. CWS Investments is a registered Broker Dealer, member FINRA, SIPC.