In commercial real estate deals, a high percentage of properties are bought and sold through Limited Liability Companies (LLCs). The primary benefit of this structure is the legal protections that come with it, but it can also make certain things more complicated – particularly when it comes to a transaction like a 1031 Exchange.
In this article, we are going to describe what a 1031 Exchange is, why a 1031 is beneficial, and how they work when there is an LLC involved. By the end, readers will have a better understanding of how to manage this wrinkle in a 1031 exchange.
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To understand how 1031 Exchanges work with LLCs, it helps to begin by defining these two key terms.
A 1031 Exchange, sometimes called a like kind exchange or tax deferred exchange, is a type of commercial real estate transaction that allows investors to defer capital gains taxes on the profitable sale of an investment property (the “relinquished property”) as long as they reinvest the sales proceeds into a new property that is like kind (the “replacement property”). To receive full tax deferral, the IRS outlines several rules that taxpayers must abide by. Among the most important:
- Investors have 45 days from the date of sale to identify a suitable replacement property and 180 days to close on the purchase of it.
- Real estate investors must reinvest all of the sale proceeds into a like kind property whose market value is equal to or greater than the value of the relinquished property.
- As it relates to this article, perhaps the most important rule is that the replacement property must be titled in the same way as the relinquished property. This can present some challenges in a multi-member LLC.
A Limited Liability Company is a business structure that provides the asset protections of a corporation and the pass through tax benefits of a partnership. In commercial real estate investing, an LLC is typically formed for each individual property and investors who purchase shares are entitled to their proportionate allocation of the income and profits produced by the investment property. An LLC may have a single member or it could have hundreds of members.
So, when a 1031 Exchange is considered for a property that is owned by an LLC, the key point here is that both properties must be titled the same way – in the name of the LLC. But, this can present several challenges depending on the number of members in the LLC and their interest in proceeding with a 1031 Exchange.
Single Member LLC Exchanges
As described above, the key issue with trying to do a 1031 Exchange with an LLC is getting all of the members of the LLC to agree to the transaction. This issue is not present with a single member LLC.
By definition, a sole member LLC only has one individual who has to decide if they want to do the 1031 Exchange or not. So, this should be a relatively straightforward transaction.
Partnership LLC Exchanges
The key challenge of a multi-member LLC is that everyone has to agree on proceeding with the 1031 Exchange to comply with the titling rule defined in the internal revenue code. For example, suppose a 20 member LLC bought a property for $1,000,000 and five years later, they have it under contract to sell for $1,500,000. In this scenario, the potential gain on sale is $500,000, which can also come with a hefty tax bill in the year it is sold.
But, two of the members have kids that are going to college and they need their share of the profit, even if it is taxable. So, they do not want to do a 1031 Exchange, which can make it very difficult to comply with the titling requirement.
It is not impossible to proceed in this scenario, but the transaction becomes more complex.
How a Partnership LLC Performs a 1031 Exchange
For tax purposes, there are three potential workaround strategies for a partnership LLC 1031 Exchange. They are described below.
Strategy #1: The Drop and Swap
A drop and swap exchange is completed with the following steps:
- Before selling the Relinquished Property, the partnership distributes the property to each of its partners in proportion to their share of ownership using a tenancy in common (TIC) interest ownership structure.
- Once complete, individual investors are co-owners with a fractional interest in the property rather than owners of shares in a partnership that owns the property. The distinction is subtle, but important for legal purposes. This is the “drop.”
- Once the distribution is complete, individual partners/shareholders are free to go their separate ways with regard to the property – including exchanging their interest in a 1031 Exchange or liquidating them for cash. In such a scenario, they work with another individual looking to join the Tenants in Common ownership structure and “swap” their interest for cash.
Although a bit more complex, this strategy allows a partnership LLC to complete the 1031 Exchange when there is one or more partners who do not wish to participate.
Strategy #2: Exchange Post Distribution
In this scenario, a partnership can achieve tax deferral if they distribute real property to each of the partners based on their pro rata share of ownership (under section 731, a partnership distribution is considered to be tax free). Once the distribution is complete, the real estate partnership is dissolved.
Following the completion of the distribution, the partners can collectively enter into an agreement with a third party to sell the property while reserving their right to complete an exchange of their partnership interest individually by assigning their interest to a Qualified Intermediary.
Strategy #3: Exchange Pre-Distribution
If all of the partners want to complete a 1031 Exchange, but can’t agree on which property to acquire, they can complete a 1031 Exchange prior to distributing the partnership interest to its members. Here is how it works.
At the partnership level, there could be an agreement to enter into a 1031 Exchange transaction that includes multiple Replacement Properties that are agreeable to the respective partners. Once the purchase of the properties is complete, the partnership can distribute them to its partners who can either keep them or sell them in a taxable event.
Working With The Experts
A partnership LLC 1031 Exchange is a complex transaction and the consequences of getting it wrong can mean a big tax bill for one or more members of the LLC. For this reason it is always a good idea to work with two types of experts to help facilitate the deal.
The first expert is known as a Qualified Intermediary and they know 1031 Exchange rules inside and out. Their job is to work with investors to facilitate the exchange transaction to ensure there are no rule violations.
The second type of expert is a CPA/tax advisor and their role is to advise on things like transaction structure and to look at the big picture impact on tax returns/income tax paid for the investor.
While these experts charge for their services, the cost can prove to be a very good investment as their advice can potentially provide significant tax savings.
Summary of 1031 Exchanges & LLCs
A 1031 Exchange, sometimes called a delayed exchange, is a real estate transaction that allows investors to defer capital gains taxes on the profitable sale of a property held for investment purposes as long as the sales proceeds are reinvested into a like kind replacement property.
A Limited Liability Company is a corporate structure that provides the asset protection benefits of a corporation and the tax benefits of a partnership. Most 1031 Exchange property transactions are conducted through an LLC.
One of the 1031 Exchange requirements is that both the sold property and the new property be titled in the same name. In a single member LLC, this is a relative non-issue. But, it can become problematic when there is a multi-member LLC where some members want to do the exchange, but others don’t.
There are a number of workaround strategies that can be used to perform a multi-member LLC including a drop and swap, exchange post distribution, or pre-exchange pre-distribution.
When completing a 1031 Exchange, it is always a best practice to work with the experts like CPAs and Qualified Intermediaries who can help facilitate the transaction and make sure it happens within the bounds of the rules.
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