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Using a 1031 Exchange as part of a divorce

Financial Planning Dentist

During the course of real estate ownership, there are instances where the transfer of property title occurs involuntarily. One such situation is when a couple goes through a divorce, which often leads to the sale of the property to a third party or the transfer of the property from one spouse to the other. Additionally, if a spouse passes away between the sale of a relinquished property and the purchase of a replacement property, it also affects the dynamics of a 1031 exchange. Let’s explore the impact of these changes in legal ownership on 1031 exchanges in more detail.

When a divorced couple intends to sell an investment or business use property to a third party, there are typically no major issues for a 1031 exchange. Despite having been joint tenants and filing taxes jointly, each spouse has the opportunity to pursue their own exchange or opt for a cash-out. Generally, the joint tenancy would have been legally severed as part of the divorce proceedings. Alternatively, the title can be severed prior to a divorce, where one joint tenant signs a deed that designates the grantor spouse as the recipient of the one-half tenancy-in-common interest.

In some cases, as part of a divorce settlement agreement, one spouse may transfer their interest in the property to the other spouse. According to 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. The basis of the transferee (the recipient) becomes the adjusted basis of the transferor. However, if the transferee wishes to sell the property in the future and carry out an exchange, they would need to exchange the entire value of the property to achieve full tax deferral.

An essential requirement for any 1031 exchange is that the taxpayer must hold the property for investment or business use. Even though the party receiving the other spouse’s interest assumes the former spouse’s basis, it does not mean they automatically inherit the other spouse’s holding period. In these situations, it would be advisable to hold full ownership of the property for a significant period before selling. Ideally, holding the property for two years or longer would be ideal, but at the very least, it should be held for a period longer than one or two tax reporting periods to satisfy the holding requirement.

On rare occasions, a taxpayer involved in a non-divorce situation may pass away between the sale of the relinquished property and the acquisition of the replacement property. While the heirs may desire a stepped-up basis in the property, unfortunately, that is not the outcome in this particular scenario. However, there is some consolation in the fact that, according to several IRS Letter Rulings, the heirs or the estate may proceed with the 1031 exchange transaction and achieve tax deferral, if not a stepped-up basis.

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Investment Bias: Confirmation

Confirmation bias is the natural human tendency to seek specific supportive sources, or overemphasize information confirming our decisions. People will often come to a conclusion, then seek information confirming the decision. Think about buying a car, once you bought the car your brain starts to highlight all the other similar cars on the road. Surely we are not conceited enough to think “there are more of this make and model because I bought the car” and yet your brain helps to draw it into our registry. It might seem backwards, but the seeking alpha and motley fools of the world know this and generate searches and lists confirming your already held conclusions. Confirmation bias can lead investors to be overconfident in an outcome, and as a result over allocate to a position and under hedge a risk. The investment consequences of this confirmation bias may also couple easily with some of the other biases we have discussed, most easily anchoring, endowment, and loss aversion. These “price point biases” are only entrenched when an investor seeks out other support for their price point. Here is a great example of this in action: Open a fresh google search and type in “is (insert company name) stock a”, and stop. Now look at the results, it will likely say “buy”, “good buy”, “good time to buy”, this is a feedback loop Google knows searchers want. Notice the lack of objectivity in the results? Our brains work similarly. We have a conclusion, then seek the supporting evidence to justify it. This overconfidence can result in a false sense that the decision is correct, and risk is not being properly rewarded. Which increases the likelihood of a misstep. A series of psychological experiments have confirmed that in our decision making process, we expel contrarian view points early and to the detriment of rational. We carry a tendency to test ideas in a one-sided way, focusing on one possibility and ignoring alternatives. Explanations for how our brain alters the observed includes wishful thinking and the limited human capacity to process a high volume of conflicting information. Another explanation, and one that might be more insidious, is that confirmation bias helps protect us (at least our ego) from the costs of being wrong.  Rather than investigating in a balanced, objective, and scientific way our brains protect us early from the possibility of having made a mistake through confirmation bias. This is an obvious investment bias. Being overly critical of criticism, and overweighting the value of consensus is not unique to investing. It happens with all of our strongly held beliefs. But investing carries the permanent impairment of wealth. I’ve even heard investors say, “this is why I get a diverse range of opinions, and use several brokers.” That doesn’t solve the bias however. It isn’t the range of options, or the volume of ideas you are evaluating. Recall that Google result was broad, and deep in its sourcing. But it’s the way the brain fabricates a positive or negative weighting as it processes that information that is the root of the bias.

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