When it comes to real estate investment, the Internal Revenue Code (IRC) Section 1031 Like-Kind Exchange remains one of the most powerful tools for deferring capital gains taxes and maximizing investment returns. By allowing investors to exchange one, or more, business or investment real estate held property for another business or investment real estate without immediate tax consequences, 1031 Exchanges promote reinvestment and portfolio growth. However, the application of this provision becomes more nuanced when disregarded entities – such as single-member LLCs and grantor trusts – are involved.
Understanding how these entities interact with the “same taxpayer” rule is critical for structuring compliant and tax-efficient exchanges.
What Is a Disregarded Entity?
A disregarded entity is a business structure or ownership feature that is separate from its owner for legal purposes but not for federal income tax purposes. The most common examples include:
- Single-member limited liability companies (SMLLCs)
- Revocable living trusts (also known as grantor trusts)
- Land trusts common in some states
- S Corporations ( S Corps)
- Certain community property held between spouses (who live in community property states)
For tax purposes, the IRS treats the activities of a disregarded entity as if they were conducted directly by the owner. This means the entity does not file its own tax return; instead, the owner reports all income and expenses on their personal income tax return.
The “Same Taxpayer” Rule in Section 1031
A keystone requirement of a valid 1031 Exchange is the “Same Taxpayer” rule. This principle mandates that the taxpayer who sells the relinquished property must be the same taxpayer who acquires the replacement property. In most cases, simply matching title vesting on the replacement property to title vesting on the relinquished property provide for adherence to this rule. This ensures continuity of ownership for tax purposes which is the original, and continuing, underlying basis for tax deferral.
At first glance, this rule might seem to preclude the use of disregarded entities. However, the IRS has clarified that certain disregarded entities do not violate the Same Taxpayer requirement, provided the underlying taxpayer remains unchanged. The “Same Taxpayer” analysis is conducted at the titleholder level, confirming that the owner of each property is the same, or is a disregarded entity of the same taxpayer.
Common Scenarios Involving Disregarded Entities
1. Individual to Single-Member LLC (or Vice Versa)
An individual who owns a property in their individual name can sell it and acquire replacement property in the name of a single-member LLC of which they are the sole member – without violating the Same Taxpayer Rule. Similarly, they could sell the relinquished property in the name of One LLC and acquire the replacement property in the name of Another LLC, provided they remain the sole member of both entities. Last, they could sell it out of their single member LLC and acquire the replacement property in their own name or into a trust as referenced below. Since the LLC is disregarded, the IRS views the individual as the taxpayer in both transactions.
This flexibility allows Exchangers to enhance liability protection by acquiring replacement property through an LLC while still enjoying the tax deferral benefits of a 1031 exchange.
2. Revocable Living Trusts
When a property is held in a revocable living trust, the IRS treats the trust as a disregarded entity. Therefore, an Exchanger can sell property held in their trust and acquire replacement property in their individual name – or vice versa – without jeopardizing the exchange. In fact, it is quite common for an Exchanger to sell property held in their individual name and acquire the replacement property in the name of their revocable living trust.
This is particularly useful for estate planning, allowing investors to align their tax and succession strategies.
3. Illinois-Type Land Trusts
Property held in an Illinois-type Land Trust allows the beneficiary, the beneficial owner of the assets, to preserve confidentiality on the public record and to receive benefits from the trust relationship not available if title was held in their personal name. The beneficiary of the land trust receives the economic benefits and burdens of ownership, as well as liability protection, while preserving confidentiality of ownership, succession of ownership, and other benefits. Thus, an Exchanger can sell property in their individual name and acquire the replacement property in an Illinois Land Trust, or other land trust, or sell out of a land trust and purchase in a single member LLC or individually. Most commonly, Exchangers who sell an asset held in a land trust will replace that asset with another held in a land trust.
4. Subchapter S Corporations
Commonly called “S Corps” or “S corporation”, this entity structure specifically allows for pass-through taxation, while also allowing the taxpayer to pay themselves a reasonable salary to avoid self-employment taxes. An S corporation is not automatically subject to federal income taxes, as the management team must select its tax attributes and allocate them to the shareholders. Even if the S corporation is being treated as a pass-through (disregarded) entity, it must file an annual information return with the IRS. In comparison with LLCs, which have no such filing requirement, this additional burden explains one of the reasons why the use of S corporations by individual real estate investors is much less common.
5. Spouses in Community Property States
For married couples who live in a community property state (Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas, Washington, and Wisconsin), spouses can own property jointly and still be treated as a single taxpayer. This results from the Statutes in those states that provide that regardless of which spouse’s name might be on title to the property, it is deemed owned by both spouses Also, if they form a two-member LLC, it may still be treated as a disregarded entity for federal tax purposes, allowing them to complete a 1031 exchange without violating the Same Taxpayer Rule.
However, in non-community property states, each spouse is considered a separate taxpayer. In such cases, they must take title in two separate single-member LLCs, or in one LLC with only one spouse as its member, to maintain compliance.
Key Considerations and Pitfalls
While the use of disregarded entities offers flexibility, investors must be cautious:
- Entity Classification Elections: Filing IRS Form 8832 to elect corporate treatment for a Single Member LLC will cause it to be treated as a separate taxpayer, disqualifying it from disregarded entity treatment.
- Timing and Ownership Changes: Any change in ownership or entity classification immediately before or during the exchange process can trigger a violation of the Same Taxpayer Rule.
- Documentation: Properly documenting the relationship between the taxpayer and the disregarded entity, as well as maintaining statutory requirements for the type of entity that is chosen, is essential to withstand IRS scrutiny.
- Holding Multiple Properties in a Single LLC: While an LLC provides asset protection, by holding multiple properties in a single LLC it does subject all properties to a claim or judgement against a single property. Placing each property in its own LLC guards against this risk. Some states allow Series LLCs that can make using separate LLCs a bit easier and less costly.
- Consistency Between LLC Ownership and Tax Reporting: In most cases, in non-community states, spouses who choose to hold title in an LLC have created a tax partnership and should be filing a tax partnership return (IRS Form 1065). Failing to do so may affect the liability protection.
Strategic Advantages
Using disregarded entities in 1031 exchanges offers several strategic benefits:
- Liability Protection: Holding property in an LLC shields personal assets from legal claims. In the event of a judgment against the LLC that owns property, only those assets owned by the LLC can be seized to satisfy the judgment.
- Estate Planning: Trusts allow for avoidance of probate and seamless transfer of assets to heirs while maintaining tax deferral. The form of trust to be employed is best determined with the aid of tax and legal advisors.
- Operational Flexibility: Investors can structure ownership to align with business goals without sacrificing tax benefits.
Disregarded entities provide a valuable mechanism for real estate investors to navigate the complexities of 1031 Exchanges. By understanding how these entities interact with the Same Taxpayer Rule, investors can structure transactions that are both compliant and strategically advantageous. It is also important to recognize that no one strategy is best for everyone – we each have unique financial positions and planning needs, requiring careful planning.
As always, it is essential to consult with tax advisors and legal counsel to ensure that the specific facts and circumstances of each 1031 Exchange align with IRS requirements. With careful planning, disregarded entities can be a powerful ally in building and preserving real estate wealth.