Vesting Issues

To qualify as an exchange under IRC §1031, title to the replacement property must be held by the same taxpayer as title to the relinquished property.  Therefore, the entity beginning the exchange must be the entity concluding the exchange.  The Qualified Intermediary will prepare the Exchange documents to reflect the vesting information as shown on the title commitment or preliminary report for the Exchanger’s relinquished property.  For example:

·      Husband relinquishes, then Husband must acquire

·      Johnson LLC relinquishes, then Johnson LLC must acquire

Exchangers must anticipate vesting issues as part of their advanced planning for the exchange.  Vesting issues are easier to resolve earlier in the transaction. However, business considerations, liability issues and lender requirements may make it difficult for the Exchanger to keep the same vesting on the replacement property.  For example:

·   If a husband, as the only Exchanger, is relying on the wife’s income to qualify for replacement property financing, then the lender will require the wife to appear on the deed, which may violate the husband’s exchange requirements.

·   Exchangers who dispose of relinquished property in one entity (such as a corporation, partnership or multi-member LLC) and who want to acquire the replacement property in a different corporation or multi-member LLC for each replacement property may not do so within the exchange format; however, conversion of a general partnership to an LP or an LLC during the Exchange Period will not disqualify the exchange.  
(PLR 99935065

The following changes in vesting usually do not destroy the integrity of the exchange:

The Exchanger’s revocable living trust or other grantor trust may acquire the replacement property in the
Exchanger as an individual, as long as the trust entity is

·   disregarded for Federal tax purposes.
 (Rev. Rul. 2004-86)

·   The Exchanger’s estate may complete the exchange after the Exchanger dies following the close of the sale of relinquished property.  (Rev. Rul. 64-161)

·   The Exchanger may transfer relinquished property held as an individual and acquire replacement property titled in a single-member LLC or acquire multiple replacement properties in different single-member LLCs. Single-member LLCs are disregarded for Federal tax purposes. (PLR 200732012)

·   In community property states, a husband and wife may exchange relinquished property held by them individually as community property, for replacement property titled in a two-member LLC in which the husband and wife own 100% of the membership as community property, but only if they treat the business entity as a disregarded entity.  (Rev. Proc. 2002-69)

·   A corporation that merges out of existence in a tax-free reorganization after the disposition of the relinquished property may complete the exchange and acquire the replacement property as the new corporate entity. (TAM 9252001, PLR 200151017)

To avoid what the IRS may consider as a “step transaction,” thereby disqualifying the exchange, the Exchanger should not make any changes in the vesting of the relinquished or replacement properties prior to or during the exchange. Please consult with a tax and/or legal advisor regarding vesting issues before transferring the relinquished property. Proper planning and negotiation can make the difference between a successful exchange and a taxable problem.