Divorce and the 1031 Exchange: Untangling a Property Two People Own

Investment property owned by a married couple becomes complicated in a divorce. One spouse may want to keep deferring tax through a 1031 exchange, while the other wants cash. Both may want the property sold, but not on the same terms.

The 1031 rules were not written with divorce in mind. They require that the taxpayer who sells the relinquished property is the taxpayer who acquires the replacement. When two spouses own a property together and want different outcomes, the order of events matters enormously.

Can spouses split a 1031 exchange?

Not easily if they sell the property together and then try to divide the exchange. If both spouses own the property and sell it jointly, each is generally treated as selling their share. Each can then decide what to do with their share of the proceeds, but the mechanics must be set up correctly before closing, with the intermediary handling each spouse's portion as their own exchange.

Where the property is held in an entity, such as a partnership or multi member LLC, the entity is the taxpayer, and the spouses cannot separately exchange without restructuring first.

How does a transfer between spouses in a divorce work?

Transfers of property between spouses, or between former spouses when the transfer is incident to divorce, are generally not taxable. The receiving spouse takes over the transferring spouse's basis.

That rule is often the key to solving the problem. Before any sale, one spouse can transfer their interest to the other as part of the divorce settlement. The receiving spouse then owns the whole property with the combined basis, and can sell it and exchange as a single taxpayer, deferring the entire gain.

The spouse who transferred the property usually receives other assets or cash in the settlement, and does not pay tax on the transfer itself.

What happens if the property is sold first?

If the property is sold while both spouses still own it, each spouse's share of the gain belongs to that spouse. Each can:

• ›Exchange their share into their own replacement property
• ›Take their share in cash and pay tax on their portion of the gain
• ›Do a partial exchange, reinvesting part and taking part as cash

Each must meet the rules individually: reinvesting their share of the proceeds, replacing their share of the debt, and meeting the deadlines. The intermediary needs clear instructions about which funds belong to which spouse.

What if only one spouse wants to exchange?

Then either approach can work, but the settlement terms need to reflect the tax difference. A spouse who takes cash from a sale will pay tax on their share of the gain. A spouse who receives the property in a transfer incident to divorce takes on the full deferred gain inside that property.

A settlement that divides assets by value alone, without considering built in tax, can be unfair. A property worth 1 million dollars with a 200,000 dollar basis carries a large deferred tax liability. The same 1 million dollars in cash carries none.

What about the replacement property?

If one spouse completes an exchange, the replacement should be titled in that spouse's name alone, or in an entity treated as that spouse for tax purposes, such as a single member LLC they own. Adding a new partner or a family member to title can break the same taxpayer rule.

What if the divorce is not final when the sale closes?

Timing matters. Spouses who are still married may file jointly or separately in the year of sale, which affects how the gain is reported. Transfers between spouses are treated favourably, but the facts of the divorce timeline, the settlement agreement and state property law all matter. Community property states add further complexity.

How is the mortgage handled?

Debt complicates divorce exchanges. If the property carries a mortgage, both spouses may be liable on the loan even after one receives the property in the settlement. Lenders are not bound by divorce agreements and may not release a spouse from liability.

For exchange purposes, whoever sells must replace the debt they are relieved of, or add cash, to defer fully. If one spouse keeps the property and later exchanges it, their debt replacement requirement includes the whole loan. If both spouses sell and exchange separately, each must replace their share.

A refinance into one spouse's name before a sale can simplify matters, but it has its own timing concerns if done shortly before an exchange. Coordinate the lender, the settlement and the exchange together.

Can the exchanged property be divided later?

Yes, but carefully. A spouse who completes an exchange should hold the replacement for investment for a sensible period before transferring it again. Transferring it to a former spouse as a delayed part of the settlement shortly after the exchange could raise questions about whether it was ever held for investment by the exchanging spouse.

What to do first

If divorce and a property sale are both on the horizon, involve the divorce attorney, a CPA and a Qualified Intermediary before the property is listed. Decide whether one spouse should receive the property before a sale, or whether both will sell and each decide individually. Make sure the settlement values reflect the deferred tax.

Nothing here is tax, legal or investment advice. Divorce and property rules depend on your facts and state law. Confirm your plan with your attorney and CPA before acting.