Over the last few months, we have written about the like-kind exchanges (also known as an IRS 1031 exchange) and the tax benefits that come with doing one. A like-kind exchange is when a taxpayer who owns an investment piece of property sells it, uses a qualified intermediary and then buys a replacement property within a short period of time.
And since many real estate investments are held in an LLC rather than by individuals, there are questions about how to do a 1031 exchange with LLC. This short guide will help you understand the exceptions and processes for using an LLC in a 1031 exchange.
Can a single member LLC perform a 1031 exchange
A single-member limited liability company is typically formed so that the individual owner of the corporate entity is not held personally liable or responsible for the entity’s transactions. The owner of the LLC is referred to as a member for legal and tax purposes. Even though the member is the only owner, a single-member LLC must still complete all required business registration filings for their particular state in order to be considered a legitimate LLC.
Back to our question, a single-member LLC can perform a 1031 exchange. If you are the only partner in a single-member LLC, you’ll have no issues if you’re the only purchaser of the replacement property. Additionally, in community property states, a married couple who are the sole members of an LLC are considered single-member LLC for 1031 exchange purposes.
How Does a Single-Member LLC Participate in a 1031 Exchange?
As per §301.7701-(3)(b)(1) of the Treasury regulations, a single-member LLC is treated as a disregarded entity for tax reporting, which means that the LLC owner is considered the owner of any real estate purchased through the LLC. This also allows the individual owner who purchased the original property to be sold in a 1031 exchange to form a single-member LLC for purposes of acquiring the replacement real estate in the exchange without taking the transaction outside of the 1031 exchange parameters.
Can a partnership LLC perform a 1031 exchange?
One of the most common questions asked of a qualified intermediary involves the situation in which one or more members or partners in a limited liability company (LLC) or partnership wish to effect a 1031 exchange and others simply wish to cash out.
Unfortunately, as we have learned over the last few decades, partnerships cause significant planning problems for partners and their tax advisors. Partners are not permitted to sell or dispose of their partnership interest and subsequently defer the payment of their capital gain taxes by acquiring like kind replacement property through a 1031 Tax Deferred Exchange transaction.
Partnership interests are specifically excluded from 1031 Exchange treatment under Section 1031 of the Internal Revenue Code. Partnership interests are personal property, and are not considered to be like kind to the acquisition of real estate, even though the underlying assets held within the partnership are in fact real property.
However, both an LLC or partnership (or any other entity for that matter) can do a 1031 exchange on the entity level, meaning the entire partnership relinquishes a property and the entire partnership stays intact and purchases a replacement property.
How Does a Partnership LLC Participate in a 1031 Exchange?
There are two major strategies a partnership LLC can adopt to participate in a 1031 exchange: Swap and Drop strategy and Drop and Swap strategy.
By using the Swap and Drop Strategy, a partnership LLC can participate in a 1031 exchange using the following steps:
- Dissolving the partnership pursuant to Section 708 of the Internal Revenue Code and paying the taxes
- Certain partners or new investors acquire those interests from those partners wanting to cash out and pay their income taxes, and the partnership completes a 1031 Exchange
- Having the partnership complete a 1031 Exchange, then refinancing the acquired like-kind replacement property(ies) after a short period of time and distributing the cash to partners who do not want to participate in the 1031 Exchange transaction (buying back the interests of those who want to cash out).
- Having the partnership complete a 1031 Exchange at the partnership level and then reorganize after a period of time under co-tenancy ownership, where two or more owners each hold an undivided fractional interest in property, then distributing property according to each co-tenants’ pro-rata interest.
- The partnership must hold the replacement property for a sufficient length of time in order to prove the intent to hold the property as rental or investment property in order to qualify for 1031 Exchange treatment (a holding period of 24 months or more is recommended given the recent changes to IRS From 1065). This is commonly referred to as a ‘Swap and Drop’ strategy.
By using the Drop and Swap Strategy, a partnership LLC can participate in a 1031 exchange using the following steps:
- Having the partnership reorganize under co-tenancy ownership where each owner has an undivided fractional interest in property then allowing each co-owner to pursue its individual investment goals.
- The tenants-in-common should hold the replacement property for a sufficient length of time in order to prove the intent to hold the replacement property as rental or investment property in order to qualify for 1031 Exchange treatment (again, a holding period of 24 months or more is recommended given the recent changes to IRS Form 1065). This is commonly referred to as a ‘Drop and Swap’ strategy.
- Having the partnership submit a valid election pursuant to Section 761(a) to opt out of the application of Subchapter K. To do so, the partnership interests must be treated as interests in individual assets, as distinguished from an interest in a partnership. Further, the partnership must be organized for investment purposes (as opposed to business purposes) and must not offer any auxiliary business services above and beyond those customarily associated with the investment either directly or through an agent.
If you are in a situation where some LLC members or some partners would like to exchange, but others don’t, consult with your tax or legal advisors and discuss the issues involved with strategies and the timing of performing what is known as “drop and swap” or a “swap and drop” alternatives. When you’re performing your 1031 exchange, you might want to consider exchanging into a Delaware Statutory Trust. Schedule your call today to discuss your options.