Divorce, Death & Tax Deferral Under IRC Section 1031

At times, in the course of real estate ownership, an involuntary transfer of title the property occurs. A couple’s divorce generally results in the property being sold to a third party or one of the former spouses conveying the property to the other spouse. Also, a spouse may pass away during the period between the sale of a relinquished property and purchase of a replacement property. What is the effect on 1031 exchanges of these changes in legal ownership?

If a divorced couple wishes to sell an investment/business use property to a third party, there are no real issues for a 1031 exchange. Regardless of having been joint tenants and filing taxes jointly, each spouse may do their own exchange or cash out. Typically, the joint tenancy would have been severed as part of the divorce proceeding. The title can also be severed prior to a divorce, by one joint tenant by signing a deed naming the grantor spouse as the transferee of the one half tenancy-in-common interest.

At times, part of a divorce settlement agreement will provide that one spouse transfers to the other spouse the interest of the exiting spouse. Under IRC Section 1041, when a spouse conveys property to the other spouse as part of a divorce, there is no taxable event for the party transferring the property and the basis of the transferee (the recipient) becomes the adjusted basis of the transferor. Should the transferee of the property wish to later sell the property and effect an exchange, he/she would have to exchange the entire value of the property to achieve full tax deferral.

Inherent in any 1031 exchange is the fact that the taxpayer must hold the property for investment or for use in a business. Even though the party receiving the other spouse’s interest assumes the former spouse’s basis, it does not mean that he/she takes over the other spouse’s holding period. It would be prudent in these cases to hold the full property ownership for a material period before selling. Two years or more would be best but at least longer than a year or two tax reporting periods would be helpful in meeting the holding requirement.

On occasion a taxpayer in a non-divorce situation may pass away between the closing of the relinquished property sale and the replacement property acquisition. While the heirs might like to receive a stepped up basis in the property, unfortunately, that will not be the result in this set of circumstances. It may be of some consolation that pursuant to several IRS Letter Rulings, the heirs/estate may continue the 1031 exchange transaction and obtain tax deferral, if not a stepped up basis.