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1031 Exchange Properties Held In Trust
To accomplish a successful tax-deferred exchange, the taxpayer that transfers the relinquished property must also acquire the replacement property. On the surface, this “same taxpayer” requirement seems straightforward, but care must be taken when the title to an asset is held in a trust.
When a property is owned by a trust, a potential hurdle is presented by the language in IRC §1031 itself. Prior to being amended in 2017 (limiting exchanges solely to real property), certificates of trust or beneficial interests were specifically excluded from non-recognition treatment under §1031. This exclusion was an extension of the similar prohibition against the exchange of stocks, bonds, or notes and partnership interests, making it clear that even before the statute was amended, these assets could not be included in a 1031 exchange.
Thus, before entering into an exchange, a determination must be made as to the nature of the trust interest in question. Fortunately, through various IRS rulings and decisions, there is some clarity regarding the application of the statute to how trusts are used in the real world.
There is one type of trust that is an alternative more flexible option to replace a 1031 exchange. It falls under this first category of trusts this article will discuss.
Irrevocable Non-Grantor Trusts
Unlike a revocable grantor trust, in an irrevocable non-grantor trust the grantor has given up all rights, title, and interest in the trust assets. The trustee of the trust, who will not be the grantor who created the trust, has full control of the assets owned by the trust, subject to the limitations of the trust agreement. Only the trustee has the power to revoke or terminate the trust. The trust must obtain its own tax identification number and file annual tax returns to report its income.
Since it is considered a separate taxpayer from the grantor and the beneficiaries, if an irrevocable non-grantor trust owns the relinquished property, it must also acquire the replacement property. Neither the grantor of the trust nor the trust beneficiaries can acquire the replacement property in their individual names.
A Unicorn Does Exist!!!
THE 1031 Exchange Alternative
The IRC 643b Compliant, Irrevocable Non-Grantor Discretionary Complex Spendthrift Trust, a non-statutory trust, is a unique trust that replaces the need for a 1031 exchange. This type of trust provides a more flexible tax defer treatment than a 1031 exchange with far fewer rules and guild lines that often make 1031 exchanges a deferral solution that does not work in certain transactions or provide the best economic outcomes that the seller may wish to accomplish. Tax Deferral Services (414-269-2600) can provide you with information about this type of trust. Significant additional benefits like full discretionary control over every aspect of the trust, asset protection, estate tax planning benefits, and flexibility to invest in whatever the trustee wants to make this trust a superior option that replaces the 1031 exchange.
Revocable Grantor Trusts
Revocable Grantor trusts have become increasingly common for estate planning purposes. In addition to other benefits, these types of trusts offer individuals a method to transfer their assets after they die without the need for probate, which can otherwise be a costly and time-consuming process. In a typical grantor trust, the grantor retains control over the property held in the trust and can either change the terms of the trust or revoke it entirely at any time. For these reasons, the trust is not considered to be a separate entity for tax purposes and any income earned by the trust is reported on the grantor’s individual tax return.
Since the trust is not a separate taxpayer from the grantor, the exchange properties can meet the same taxpayer requirement regardless of whether the title is held in the taxpayer’s individual name or in the name of the trust. For example, the taxpayer may hold the relinquished property as an individual but acquire the replacement property in a revocable living trust and vice versa.
Land Trusts
At first glance, Land Trusts would seem to present a unique problem, especially in Illinois. The beneficial interest in an Illinois land trust is treated as personal property under state law, and personal property may no longer be exchanged under IRC §1031. However, despite this treatment under state law, in Rev. Rul 92-105 the IRS determined that a taxpayer’s interest in an Illinois land trust constitutes a real property interest for purposes of IRC §1031 and the IRS will treat that interest as like-kind for the purpose of an exchange. The rationale was that the trustee is merely an agent that acts to hold and transfer title, not a trustee who actively works to protect and conserve property for a beneficiary. Additionally, the beneficiary has the obligation to pay any taxes and liabilities of the property, as well as the exclusive right to (i) direct the trustee in dealing with the title, (ii) control the management of the property, and (iii) receive the earnings from the property.
Several other states have ownership arrangements that are similar to an Illinois land trust, notably Florida, California, Hawaii, Indiana, North Dakota, and Virginia. Rev Rul. 92-105 should apply to these and other similar arrangements created under state law. However, it is important to note that the holding in Rev. Rul. 92-105 is not applicable if such an arrangement creates an entity (such as a partnership).
Delaware Statutory Trusts (DST)
Under Delaware law, a DST is an entity that is recognized as separate from its owners. The beneficial owners are entitled to the same limitation on personal liability that is extended to stockholders of Delaware corporations, unlike the beneficial owners in an Illinois land trust.
Accordingly, because a DST is considered an entity that is separate from its owner, a determination must be made as to whether it is a trust or a business entity for federal tax purposes. If the DST is a trust, then the individual beneficial owners can exchange their interests under §1031.
The guidelines for this determination are specified in Rev. Rul. 2004-86. The trust agreement reviewed in this Revenue Ruling provided that the trustee’s activities were limited to the collection and distribution of income. For example, the trustee could not exchange for other property, renegotiate the terms of the debt used to acquire the property, or renegotiate leases with the tenant, among other limitations. Because the DST’s trustee had none of the powers which evidenced an intent to carry on a profit-making business, the DST in question was classified as a trust, and the beneficial interests were considered ownership of the underlying real property owned by the trust and thus could be exchanged pursuant to IRC §1031.
CONCLUSION
Despite the historical statutory prohibition against 1031 exchanges of “certificates of trusts and beneficial interests” it is possible to exchange properties owned by trusts. However, in structuring exchanges with trusts, it must be determined which taxpayer is the owner of the property for tax purposes. Trust ownership is complex and there may be additional factors that affect this determination. This article provides a broad overview and is not intended to be a complete summary of all issues that might arise. Accordingly, it is essential that investors consult with their tax and legal advisors in structuring any exchange involving trust-owned property.
Our recommendation would be to learn about the IRC 643b Compliant, Irrevocable Non-Grantor Discretionary Complex Spendthrift Trust. All of the issues and complexities in this article involving trust ownership of real estate can be eliminated if you utilize this unique 643b compliant trust. Simplify your financial and tax planning life all with one trust! For more information contact Adam j Ausloos at 414-269-2600 or adam@defernow.com.
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Tax Deferral Services, is not a financial or real estate broker, agent or salesperson, and is precluded from giving financial, real estate, tax or legal advice. Consult with your financial, real estate, tax or legal advisor about your specific circumstances. Tax Deferral Services makes no express or implied warranty respecting the information presented and assumes no responsibility for errors or omissions.
