Divorce 1031 Exchange

In a divorce, the community property assets have to be divided somehow between the spouses.  Often this is worked out with the help of a divorce mediator.  When a couple owns commercial, business or investment real estate, sometimes the possibility of doing a 1031 exchange arises.

A 1031 exchange provides a tax break when selling commercial, business or investment real estate.  It allows the property seller to swap out a property for another and defer tax on the sale of the previously-held property.  Otherwise, you’d have to pay tax at the time of the sale.

The intent of this article is to provide some 1031 exchange basics and divorce-related considerations.  If you are serious about doing a 1031 exchange, you should get assistance from experienced 1031 professionals.

Example

Let’s say you purchased rental residential real estate for $500,000 in 2012.  It’s now worth $900,000.  If you sell, your capital gain is $400,000 and you must pay tax on it.  These state and federal taxes would include capital gains tax and depreciation recapture tax.

To avoid that, you do a 1031 exchange in which you invest the whole sale proceeds (say $900,000) into another like-kind property.  This enables your real estate investment to keep growing tax-deferred as you roll your profit over.  You can do this as many times as you want.  You’ll only have to pay tax on your investment once – when you finally cash out many years later.

Basics

The Internal Revenue Code (IRC) Section 1031 provides the legal framework for these exchanges.

A 1031 exchange cannot be done with a personal residence.  Nor can you exchange for a personal residence.  However, you can convert the purchased property to a personal residence after two years.

Exchanges must be between like-kind properties, which the IRS defines as properties “of the same nature or character, even if they differ in grade or quality.”  For example, you can exchange:

• an industrial building for an office building you’ll lease to businesses;
• land used for commercial purposes for a warehouse building;
• an apartment building for another residential rental real estate property.

It’s unlikely that the person selling the property you want to buy also wants to buy the one you’re selling.  Therefore, most exchanges are “delayed.”  This means that a qualified intermediary will hold the cash from your sale in escrow and use it to buy the replacement property for you.

Rules for a 1031 Exchange in California

1. You must purchase a like-kind property.
2. Each property must be in the USA.
3. Your new property must be of equal or greater value (to fully defer tax).
4. You must invest all the sale proceeds in the new property.
5. The new property must stay under the same taxpayer’s name.
6. Within 45 days of the sale of your property, you must advise your intermediary what property you are going to buy.
7. Within 180 days of the sale of your property, you must complete the purchase of the replacement property.
8. All parties involved in the exchange must hold their properties for a minimum of two years.

You can also do it the other way around, i.e. buy the property you want, name the property you want to sell within 45 days, and then sell it within 180 days.

1031 Exchange Considerations in a Divorce

If the property to be sold is community property, each spouse must own an equal share of the property for it to be eligible for a 1031 exchange.  Since one of the IRS’s rules is that the purchased property be held in the same name(s) as the sold property, this implies that the couple would continue to own jointly the newly purchased property even though they are getting a divorce.  And each spouse would need to agree with the exchange.

For this reason, 1031 exchanges are most common after the divorce has been finalized and all assets have been divided.  Then each spouse is free to pursue a 1031 exchange of any investment or business property they were awarded in the divorce, without the need to involve their ex-spouse.

This enables each spouse to choose replacement properties that best suit their individual needs post-divorce.  For example, if one spouse plans to move away, they may prefer to acquire a replacement property in this new location.

Benefits

The main possible benefits of a 1031 exchange are:

1. Deferring taxes leaves you with more money to invest or spend now.
2. You can trade one property for multiple properties to diversify your investments.
3. You can exchange multiple properties for one if say you want to spend less time managing them.
4. You can trade your property for another that generates greater returns over time.
5. You can use 1031 exchanges for estate planning. Tax liabilities end with death so your heirs won’t have to pay your deferred tax.

Other Considerations

There are quite a few fees and closing costs you’ll have to pay. Fortunately most are tax-deductible or at least not taxed.

California (and all 50 states) recognize 1031 exchanges as long as all the properties are located in the USA.  Most states simply follow the federal Internal Revenue Code Section 1031, but not all.  If you do an exchange from California to another state, be aware that California has a “clawback” provision on state taxes.

It is essential that all IRS requirements are met.  It’s wise to involve 1031 professionals (lawyers, realtors, tax specialists, Qualified Intermediaries) to ensure the exchange meets these requirements and is structured in the most advantageous way.

Carefully document all transactions related to the 1031 exchange process.  This includes property valuations, purchase agreements, closing statements, loan documents, and correspondence related to the exchange.  These documents may be necessary for tax purposes and may also be required if there are any future disputes or challenges.