There are a couple of potential issues that need to be addressed here. The first issue, which I will address, is structuring the transaction so that it will qualify for 1031 exchange treatment. The second issue is whether deeding the property out of the S corporation will create any corporate taxation such as a liquidating dividend, etc. I will ask Tim Folkers, CPA to address this issue.
First, the answer to your question is yes, you can accomplish what you are tyring to do. This transactional structure is what we refer to in the 1031 exchange industry as a drop and swap. You deed the property out (drop) of the S corporation into the individual shareholder(s) name as a tenant-in-common and the tenant-in-common can not treat his or her interest in the real estate as their own and proceed as they desire including pursuing a 1031 exchange (swap) upon the sale of the property. There are, however, a few additional steps that should be taken before proceeding with a 1031 exchange, including checking with your tax advisor to ensure that you do not create any other corporate taxation issues.
The most important concept here to understand is that the taxpayer completing a 1031 exchange must have the intent to hold the property as investment property, so the shareholder(s) receiving the deeded interest in the real property should treat the property as their investment property, including reporting it on their own individual income tax return as investment real estate. The majority of tax advisors recommend that the shareholder (now a tenant in common or TIC) hold title for at least 12 or more months in order to demonstrate they did in fact have the intent to hold the property for investment. Remember, the S corporation has held title for quite sometime, but the shareholder (a different taxpayer) just received title to the real property through the drop.
Taxpayers that drop the property out of the S corporation and then immediately turn around and complete a 1031 exchange (swap) run a huge risk that the tax-deferred exchange would be disqualified under audit because they did not hold the property sufficiently long enough to demonstrate their intent to hold for investment purposes. You may not have a choice, but you will be assuming a substantial risk during an audit.
There may be other solutions depending on the other shareholders' goals and objectives and their willingness to cooperate. You could structure a swap and drop, which is essentially the opposite of the above transaction if the other shareholders are all willing to stay together for 12 to 18 months. This is essentially completing the 1031 exchange (swap) inside the S Corporation where the S corporation sells the relinquished property and the S corporation acquires one or more like-kind replacement properties and holds these properties for 12 months or more to complete the 1031 exchange transaction. The properties could then be deeded (dropped) to the various shareholders after the 12 to 18 months has passsed.
There are many versions of this, so you should make sure that you have a good legal and tax advisor and an expert Qualified Intermediary that has experience in structuring these transactions such as Exeter 1031 Exchange Services, LLC.
Tim, can you comment on the corporate taxation issue?
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