UNRAVELING THE MYSTERY OF 1031 EXCHANGES: THE EXACT SAME TAXPAYER REQUIREMENT

By

William L. Exeter

Chief Executive Officer

Exeter 1031 Exchange Services, LLC

Exeter Trust Company

In the complex landscape of 1031 tax deferred exchange transactions, a persistent misconception often causes unnecessary confusion for investors and real estate professionals alike. It is widely—and incorrectly—believed that the legal title to the real estate being sold (the relinquished property) and the real estate being purchased (the replacement property) through a 1031 exchange must be held under the exact same legal name.

While holding real properties under identical legal titles is a safe and generally recommended practice, it is not an absolute rule. The Internal Revenue Code focuses on a different standard entirely. Understanding this critical distinction can provide investors with greater flexibility, particularly when dealing with stringent lender requirements.

Understanding the Same Taxpayer Requirement

The actual mandate for a successful 1031 exchange transaction is that the ownership of both the relinquished and replacement properties must remain with the "same taxpayer." The taxpayer that sells the original relinquished property must be the same one who purchases the new replacement property, regardless of how the legal title is recorded on the deed.

Interestingly, this same taxpayer requirement is an implicit rule. It is not specifically detailed in the Internal Revenue Code or Treasury Regulations. However, it operates as a fundamental principle of tax-deferred exchanges. Legal title can vary from the sale of the relinquished property to the purchase of the replacement property, provided the underlying taxpayer remains identical for federal income tax purposes. (i.e., the underlying taxpayer identification number remains exactly the same). 

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The Power of Disregarded Entities                                                                              

Real estate investors have several compliant pathways to acquire and hold legal title to real estate while successfully meeting the same taxpayer requirement for a 1031 exchange. This flexibility is typically achieved through the strategic use of disregarded entities.

A disregarded entity is a business structure that the IRS ignores for federal income tax purposes. These entities do not file separate federal tax returns. Instead, the IRS treats the underlying investor as the actual owner and taxpayer for tax purposes.

The following ownership/entity structures are treated as if the real properties are owned directly by the underlying taxpayer (e.g., trustor, member, or beneficiary) as long as the entity continues to be classified as disregarded:

• The investor’s individual name (no entity)
• A single-member limited liability company (LLC) that has not elected to be taxed as a partnership or a corporation
• A fully revocable grantor trust, such as a living trust
• A title holding trust (land trust) under Revenue Ruling 92-105
• A tenant-in-common (TIC) ownership structure under Revenue Procedure 2002-22
• A Delaware Statutory Trust (DST) ownership structure under Revenue Ruling 2004-86

Real-World Applications and Lender Requirement

Lenders frequently dictate how legal title must be acquired and held to secure financing for a replacement property. Many financial institutions refuse to underwrite loans if the title is held in a trust or an LLC, while others might explicitly require a special purpose entity such as a limited liability company.

Consider an investor who holds legal title to their relinquished property in a single-member LLC. To approve the new mortgage loan, the lender demands that the replacement property be titled in the investor’s individual name and not the single-member limited liability company. If the single-member LLC is also a disregarded entity, the IRS treats the individual as the actual taxpayer or property owner. The same taxpayer requirement is fully satisfied, even though the legal titles differ.

The exact same logic applies to fully revocable grantor trusts, usually referred to as living trusts. If an investor sells a relinquished property held in a revocable grantor trust but must buy the new replacement property in their individual name to satisfy lender mandates, the exchange remains compliant. The living trust is a disregarded entity unless it has become an irrevocable trust, and the underlying individual taxpayer remains consistent throughout the 1031 exchange transaction.

The key is to ensure that the sale of the relinquished property and the purchase of the replacement property are completed by the exact same taxpayer and not necessarily the exact same legal title.   

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Navigating Regarded Entities and Unexpected Events

It is vital to recognize that not all entities enjoy this flexibility (i.e., not all entities are disregarded entities for federal income tax purposes). Regarded entities—those that file their own federal tax returns—must generally hold the relinquished and replacement properties under the exact same legal title. These include multi-member LLCs, general and limited partnerships, "C" and "S" corporations, and irrevocable trusts.  However, regarded entities can form new disregarded entities, often new single-member limited liability companies, owned 100% by the same regarded entity to acquire the replacement property.  The new single-member limited liability company and disregarded entity is treated as if the underlying regarded entity is the actual taxpayer for federal tax purposes. 

Additionally, the Treasury Regulations provide specific protections if a taxpayer passes away in the middle of an active 1031 tax deferred exchange transaction. If the sale of the relinquished property has already closed, the taxpayer's estate or trust must complete the acquisition of the replacement property to secure the tax-deferred treatment and receive a step-up in cost basis. While the taxpayer and their estate are technically distinct, separate entities, the regulations and rulings offer a clear exception to preserve the exchange.

The Importance of Professional Guidance

The intersection of legal title and taxpayer identity requires precise, factual analysis. A misstep in structuring the transaction can lead to the disqualification of the 1031 exchange transaction, triggering substantial and immediate tax liabilities.

Investors must protect their investments by prioritizing proactive planning. Investors must always consult with qualified legal, tax, and financial advisors before initiating any tax-deferred exchange transaction. By understanding the same taxpayer requirement and working with experienced professionals, you can confidently navigate the nuances of 1031 exchanges and secure your wealth-building strategies.

About William “Bill” L. Exeter

Mr. Exeter is the founder, Chairman and Chief Executive Officer of The Exeter Group of Companies, including Exeter 1031 Exchange Services, LLC and Exeter Trust Company.  He began specializing in real estate tax strategies in 1985 with a specialty emphasis in 1031 exchanges, 1033 exchanges, self-directed IRAs and individual 401(k) plans, title holding trusts (land trusts), specialty holding escrows and custody accounts, with an emphasis on alternative investments. He also serves as an industry consultant, advisor, trainer, instruc...

Mr. Exeter has written, lectured, taught, and trained investors and real estate professionals extensively on 1031 exchanges, 1033 exchanges, 721 contributions, 121 exclusions, tenant-in-common (TIC) and Delaware Statutory Trust (DST) investments as replacement property solutions for 1031 and 1033 exchanges, self-directed IRAs and individual 401(k) plans, and title holding trusts or land trusts.

He has been in the financial services industry for over 41 years, has administered more than 125,000 1031 exchange transactions, and is one of the founding members of the 1031 exchange industry’s trade association, the Federation of Exchange Accommodators.  He has administered thousands of self-directed IRAs and individual 401(k) plans, specialty holding escrows, title holding trusts (land trusts) and custody accounts during his extensive career.