Land Trusts and 1031 Tax Deferred Exchanges

What is a Land Trust? 

The term “Land Trust” is generally used in several different contexts, including in connection with open land conservation. However, this blog pertains to the type of land trust that is often used by people, or other legal entities, to separate the title to real estate from the beneficial ownership of the property. This separation is created by the property being deeded at the time of acquisition, or sometime thereafter, by placing title in the name of the Trustee and creating a trust instrument, a Land Trust Agreement, naming the trust beneficial owner, otherwise known as the Beneficiary. In most cases, the Trustee is a corporate trustee who is in the business of acting in this capacity and receives an annual fee for its services. In some cases, an individual is named as the Trustee. The land trust is disregarded for tax purposes, and the beneficiary of the trust receives the economic benefits and burdens of the ownership. The land trust provides certain liability protection, confidentiality of actual ownership, succession of ownership, as well as certain other benefits that users are sometimes seeking. 

Land Trust Origins 

The origins of land trusts date back to medieval times when all real estate was owned by the King but granted to noblemen who fought on behalf of the King. But when the nobleman died fighting in wars in his service to the King, the land reverted back to the King, who could dole it out to a new loyalist. Creative thinking at the time, lawyers (likely) came up with this idea of taking the land handed out and putting title under the name of a Trustee for the benefit of the nobleman. Therefore, the nobleman’s death in support of the King would not cause the property to revert since the title would not be affected by the death. The land would remain in the trust for the benefit of the named successor beneficiary(ies). Separating title from the use and benefit of the property also solved another problem in those times. When a property owner holding title did not wish the property to transfer to his first-born son up his death, which was the law at the time, the land trust allowed the initial beneficiary to name others in the family to succeed him in beneficial ownership. 

Eventually the State (the King) realized that this legal arrangement limited its important control over property ownership. In 1535, a new law was passed known as the “Statute of Uses”. Essentially, it provided that regardless of how title was held, whomever had the “use and benefit” of the property ownership was deemed the legal owner. The law applied only to passive trusts where the actual duties of the Trustee were negligible or non-existent, versus an active trust where the Trustee had true duties, decision making, etc. The passive trust was no longer legally recognized, and the Statute of Uses became part of the Common Law in England. 

The Evolution of Land Trusts in U.S. Law 

Fast forwarding to the early days of the United States, as a core body of law to follow, most states adopted the Common Law of England. In the late 1800s and again in the 1920’s, the Illinois Supreme Court reviewed a couple of trust arrangements that would in time become land trusts as we known them today. Essentially, the trust agreement before the court provided that the Trustee held legal title to the property and would take direction from the beneficiary. For all intents and purposes, the Trustee had no independence nor active responsibility. The court examined the land trust document and found the following: 

• The Trustee had duty to take action upon direction from the beneficiary 
• The Trustee had duty to apprise the Beneficiary of anything it received as record titleholder 
• The trust term was limited to 20 years 
• If the trust was still in place after 20 years, the Trustee had to hold a public sale of the property and distribute the proceeds to the Beneficiary(ies) 

Review of the facts and circumstances might lead to the conclusion that this was a passive trust, and therefore not valid. However, the Illinois Supreme Court found that these very limited duties were still enough to cause the trust to be active and, as such, valid. Over the years, many other state courts had occasion to rule on the same type of trust arrangement and for the most part found them to be passive and violated the Statute of Uses. As a result, the land trust flourished particularly in Illinois. Today, some states allow them due to case law and some under statutory authority. Below is a list of states that recognize the conventional land trust: 

• Illinois 
• Indiana 
• Florida 
• Hawaii 
• Virginia 
• South Dakota 

Impact of 2017 Tax Law on Land Trusts and Like-Kind Exchanges 

Prior to 2018, a like-kind exchange could take place not only for real estate, but also such things as personal property and intangibles. This included a broad range of assets, personal property included such things as machinery, equipment, aircraft and railcars, whereas examples of intangibles include fast food and hotel franchise rights and territorial product distribution rights.   

Among other things that were not permitted historically under the Code for exchange treatment included interests held under certificates of trust or beneficial interest. A holder of an interest in a land trust is considered to hold the beneficial interest and that interest in considered personal property. After signing into law, The Tax Cuts and Jobs Act (TCJA) effective January 1, 2018, Section 1031 was changed to simply allow real estate exchanges and nothing more. So, while holding a beneficial interest was never allowed, after the start of 2018, neither was a personal property interest. 

Holding interest in real estate in land trusts have always been very common. As mentioned above, among many other benefits, they are used as a form of asset protection, similar to the use of a limited liability company. At one time, there was concern by people and their advisors that an exchange might not qualify due to the fact that the (“Exchangor” or “Taxpayer”) Person intending to conduct a 1031 tax deferred exchange, who transfers a relinquished property and thereafter receives a replacement property. Exchanger ’s interest was defined as holding the beneficial interest in the trust. This led to a considerable number of people to request some clarity on the part of the IRS. This resulted in the issuance of Rev. Rul. 92-105 which stated that:  

“A taxpayer’s beneficiary interest in an Illinois land trust constitutes real property which may be exchanged for other real property without recognition of gain or loss under IRC §1031 provided that the requirements of that section are otherwise satisfied”. 

This removed any uncertainty about the qualification under §1031 for an (“Exchangor” or “Taxpayer”) Person intending to conduct a 1031 tax deferred exchange, who transfers a relinquished property and thereafter receives a replacement property. Exchanger selling property that was held under a land trust. In addition, by deeming it “real estate,” in 2018, when “personal property” was dropped from the type of assets capable of being exchanged, this had no effect on selling out of a land trust. 

Considerations for Land Trusts in 1031 Exchanges 

The presence of a land trust holding title to a property that is being sold as Relinquished Property   in the first leg of an exchange can require extra care when administering an exchange. Technically, since the title to the property and the deed to the The purchaser of the taxpayer's relinquished property. Buyer is in the name of the Trustee, the Trustee should also be the signer of the PSA, but this is not always the way PSAs are completed and signed in practice.   

Some of the variations in the preparation and signature on a PSA involving land trust property are: 

• The PSA will reference the land trust as Individual or entity that owns replacement property desired by the taxpayer. Seller , and it will be signed by the Land Trustee 
• The PSA will reference the land trust as Individual or entity that owns replacement property desired by the taxpayer. Seller , but it will be signed by the Beneficiary with an express reference to the Beneficiary signing in his capacity as such 
• The PSA will reference the land trust as Individual or entity that owns replacement property desired by the taxpayer. Seller and the Beneficiary will just sign on the signature line in his own name with no further reference to his capacity 
• The PSA will simply show the Beneficiary as the Individual or entity that owns replacement property desired by the taxpayer. Seller and will be signed as such (with no reference to the land trust) 

The manner of execution can pose legal risks, specifically, risks as to the contract enforceability, but that is another topic. 

When using the Qualified Intermediary safe harbor under the exchange Regulations, it is required that “…the rights of a party to the agreement are assigned to the intermediary and all parties to that agreement are notified in writing of the assignment…”.  Due to the many ways a PSA may describe the Seller and how it might be signed, the When a taxpayer is doing a delayed exchange, it has to link the sale and the later purchase together as an exchange of the one for the other. This is accomplished by transferring the relinquished property to the qualified intermediary and receiving back the replacement property from the qualified intermediary. In order to make this process as simple as possible, the IRS regulations state that by the taxpayer assigning the rights under the sale and purchase contracts to the qualified intermediary, for tax purpose that is sufficient to deem the properties to be exchanged between the taxpayer and the qualified intermediary. Assignment of Contract Rights and Notice need to correspond to the named party(ies) even if the title to the property is held by a land trust. When in doubt, the other selling party can be added to the documents, as it would be better to have an extra party than to leave out a necessary party. 

In summary, in some states, land trusts are a common way for title to real estate to be held.  Due to the origin of the land trust concept and the interpretation of various state courts they are not available in every state. Some documents effecting the real estate, like a mortgage/deed of trust, as a legal matter have to be signed by the legal titleholder (i.e. the land trust). Other documents such as contracts and leases are sometimes signed by the land trust Beneficiary directly. Ideally the document references their capacity as Beneficiary. In any event, the exchange Regulations require adherence to form which requires exchange documents to reflect parties to the PSA, notwithstanding how legal title is held.    

 
The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified A person acting to facilitate an exchange under section 1031 and the regulations. This person may not be the taxpayer or a disqualified person. Section 1.1031(k)-1(g)(4)(iii) requires that, for an intermediary to be a qualified intermediary, the intermediary must enter into a written "exchange" agreement with the taxpayer and, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer. Intermediary , and as such does not offer or sell investments or provide investment, legal, or tax advice.