I bought a one-acre property with a house and three cottages in July 2006 by 1031 exchange using proceeds from sales of some of my own rental properties. I treated the entire property as investment property, renting portions while I renovated other portions. In May 2008, my wife and I moved from our home to a portion of the new one-acre property which I had renovated as a residence, while the rest of the one-acre property remained rented to others. Our former home was converted to rental property, but we still qualify for the homeowner exemption on gain if we sell that. My wife now wants to sell some of her own rental properties and roll the proceeds into the rental portion of my one-acre property as a 1031 exchange. How can we do this?

I have a couple of questions for you first.  You stated that you are married.  Are you in a community property state?  Do you file a joint income tax return?  Who reports the property and acreage for income tax purposes currently? 

I am married. My spouse and I each hold investment properties separately, in our individual names. The state where we live and where the properties are located is not a community property state. We file a joint return or separate returns depending on the effect on our tax obligations, because, among other things, filers of a joint return are treated as one taxpayer. But we maintain separate accounts and records and management and financial activity for our different properties (mine and hers) so that we can file our tax returns separately if we choose. The most recent return filed was a joint return but it did not involve the property, owned individually by me, into which we may want to transfer sales proceeds from some of my wife's investment property by 1031 exchange, nor did it involve her particular investment properties which she might exchange. I think I see where you are going, however. One question would be whether having filed jointly a return which covers any of the properties proposed for exchange, does that make both of us "owners" of all of those properties in the eyes of the IRS and therefore make the properties ineligible for 1031 exchange among these properties by either of us. I wouldn't think so, because the code does allow and provide rules for 1031 exchanges between related parties. And I thought the question was complicated enough to begin with.

Wall-e:

IThe most recent return filed was a joint return but it did not involve the property, owned individually by me, into which we may want to transfer sales proceeds from some of my wife's investment property by 1031 exchange, nor did it involve her particular investment properties which she might exchange.

I was confused about the statement above.  Where and how were the properties reported?  How are they held?  Are they owned by an entity or in your names as sole and separate properties?  The issue or concern is not that you are "related parties," which can be addressed, but whether you are considered the "same party," in which case you can not 1031 exchange with yourself.

These properties were purchased after the year for which our most recent tax return was filed. Each of us holds his or her property in his or her individual name, as sole and separate property held by individuals and not in any other entity. I think the expression is "tenancy by severalty."

Your proposed 1031 exchange would not qualify.  It is not a related party issue, but you would be considered the same party for 1031 tax deferred exchange treatment.  You are not permitted to 1031 exchange into your own property. 

Dear Mr. Exeter: Thank you for your quick response. To help me understand your conclusion, can you tell me what part of the IRC makes the two of us the "same party," especially in light of my answers to your previous questions: 1. We are married. 2. The state where we live and where the properties are located is not a community property state. 3. We purchased each and all of the properties in question separately in our own names. 4. We maintain completely separate independent individual ownership, management, income and expense accounts, records and activity for the properties in question. 5. Although we have filed both individual and joint tax returns since our marriage, we have not yet filed any tax returns involving any of these properties. 6. Although we now reside in a portion of the property into which my wife would like to exchange proceeds from sale of her separate investment property, I treat the rented portions of the property separately as investment property and distinguish it from the portion of the property in which we reside. Finally, is there any "cure" which would enable my wife to make a tax free exchange into the subject property--or another way to move the equity value of her property into mine without triggering tax consequences? Thanks again for your help.

Yes, you are married, filed a joint income tax return last year, have filed joint income taxes in the past, both of you live on the property in question, etc.  My position is based on case law, private letter rulings, etc.  However, having said that, I am not a tax attorney or advisor, and you may wish to retain one for a more in depth review with specific citations that you can review. 

I think the IRS would take the position that you are 1031 exchanging into property that you already own.  However, let's assume that you proceed with the proposed transaction under the assumption that the property is not owned by your wife and that you are not considered to be the "same taxpayer".  I think you and your wife would be treated as related parties by marriage and would be subject to the related party requirements.  The first is a two year holding period, which I am assuming would not be an issue in your case.  The second issue however is whether or not there is "basis swapping" going on.  I'm assuming that your wife would sell appreciated property, complete a 1031 exchange by acquiring an interest in property from you, which you recently acquired so that there would be no capital gain to you, which is a classic case of basis swapping and would not qualify for 1031 exchange treatment under Revenue Ruling 2002-83.  The act of deferring gain on appreciated property because of a low basis by acquiring property from a related party with out triggering gain on the related party's part because their basis is so high is considered to be basis swapping and will not qualify for 1031 exchange treatment.

I can not see any way around the rules with out incurring a significant risk that the transaction woud be disqualified as a 1031 exchange.