These days, with the U.S. economy on unstable ground, and with many Floridians still recovering financially from the COVID-19 pandemic, any tips to save money or maximize income should come as very welcome advice. IRC Section 1031 exchanges can be excellent tools to achieve both of these aims: exchanges can defer taxes (saving) and also simultaneously build wealth (income maximization). For those who are looking to conduct a 1031 exchange prior to a divorce, there are all sorts of questions likely to be floating around. In this post, we will go over the mechanics of a pre-divorce 1031 exchange so that taxpayers are aware of the process, the risks, and the steps which need to be taken to ensure full compliance.
The Mechanics of Pre-Divorce 1031 Exchanges
The mechanics of a pre-divorce 1031 exchange will resemble any given exchange, but there are several critical considerations. The first thing to consider is how precisely the real property is being held. Real property can be the sole and separate property of one spouse, or it can be jointly held as a married couple (i.e. marital property). The key thing to keep in mind here is that there must be “entity consistency” on both sides of the transaction, which means that whatever entity sells must also be the same entity which acquires replacement property. Taxpayers need to firmly pin down how property is being held to ensure compliance.
As we will discuss further, pinning down how title is held is instrumental in ensuring compliance with the holding requirement too. Outwardly, a pre-divorce 1031 exchange will have the same structure as any other: there must be proper identification of replacement property, including identification within 45 days, everything must be completed within a total of 180 days, a proper exchange contract must be executed, and so forth.
Primary Issue: Meeting the Holding Requirement / Same Entity Requirement
The same entity requirement is a firm requirement, as has been established by the case law. Issues can easily come up with this requirement when conducting a pre-divorce exchange because separate property may be incorrectly treated as marital property in the sale documentation. If, for instance, a piece of property is mistakenly titled as marital property, but is in fact separate property, the tax authorities could collapse the exchange.
The holding requirement – a requirement which derives directly from the plain language of the code – may pose a challenge, depending on the specific facts, in pre-divorce exchanges. The reason why this may present a challenge is because spouses typically wish to alter the ownership structure after the exchange. This can lead to a situation in which the tax authorities can potentially argue that the holding requirement wasn’t met. Consider a common scenario: a married couple owns property jointly and holds it for investment. After an exchange, the married couple obtains a divorce, and then subsequently the ownership is changed, either by transferring everything to one party or the other, or by placing the property in a jointly owned LLC, or some other entity. In any case, since the ownership has changed, the tax authorities may argue that the couple didn’t “intend to hold” the replacement property for investment. This can potentially collapse the exchange.
Another common scenario would be a piece of real property is placed in an irrevocable trust during the marriage, is held for investment, used in a 1031 exchange, and then the trust is terminated. Again, this opens up the possibility of the holding requirement being brought into question by tax authorities.
Contact Miami Family Law Group, PLLC for More Information
Miami Family Law Group, PLLC has over 25 years of experience serving families in Miami. We strive to assist our clients with all aspects of the divorce and separation processes, including conflict resolution, therapist referrals, and finance management referrals. We will help you divorce yourself from the fight and find peace of mind as you make a fresh start.
Call us today at Miami Family Law Group, PLLC at (786) 551-4179 or contact us online to schedule a strategy session for legal advice with a legal separation attorney in Miami, FL.
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