Often times, a taxpayer will choose to hold his/her investment property in the name of a disregarded entity or single member limited liability company (SMLLC), which allows the owner to be taxed on their personal tax return. The intent is that the owner's personal liability is protected because the title of the property is held in the name of the SMLLC. Determining the merits of owning property in a SMLLC should be discussed with your tax and legal advisor.
A disregarded entity may still enter into a 1031 exchange and reap the benefits of deferred capital gains tax. When the owner is simply a single person, the process is quite simple. The same taxpayer requirement applies for a disregarded entity as it would if the property was owned in the name of the individual. The taxpayer who sells is the taxpayer who must acquire, with the exception of a disregarded entity. If held as a disregarded entity, then the taxpayer may acquire the replacement property or vice versa. The properties being exchanged must be held for investment or for trade or businesses, they must be of like-kind to one another, and the complete exchange must occur within 180 days of the sale of the old property. To defer the realized gain, the replacement property must be equal to or greater than the relinquished property, otherwise the difference is taxed.
Example: John holds his investment property, which he is selling for $200,000, in the name of an SMLLC for liability purposes. He acknowledges that he will be completing a 1031 exchange. John may purchase the replacement property as an individual or in the name of the disregarded entity. The new property's purchase price is $250,000. Any capital gains tax that would be due from the sale may be deferred because John or the disregarded entity is re-investing 100 percent of the sales proceeds into the new property.
Drop and Swap
Taking the disregarded entity a step further, a 1031 exchange can carefully be completed with a multiple member limited liability company (MMLLC). Sometimes partners in an investment may disagree on the use of the proceeds from the sale of their shared interest. One partner may want to complete a 1031 exchange and re-invest the proceeds with no capital gains tax, while the other may want to cash out and move on. The so-called "drop and swap" can be an option in this situation. Prior to the sale of the old property, the partnership of the MMLLC will be dissolved and will distribute the property as tenant in common interests to each individual member. This is the "drop" in the transaction because the MMLLC is dropping to individual's names. The sales contract needs to be entered into as tenants in common. Because the ownership structure is now tenants in common, upon the sale of the old property, one partner may exchange his/her interests into a replacement property, while another partner may decide to cash out and be liable for the capital gains tax.
A "drop" and "swap" can have its risks. Dropping the property to common in tenants status should be done a year in advance to ensure that the property will qualify for 1031 status. This is not a hard-and-fast rule, but the Internal Revenue Service (IRS) will likely look more closely if the drop occurred less than 12 months prior to the sale. Another aspect the IRS will potentially put a microscope to is the operation. Once the "drop" occurs, any activity must follow that of tenant in common interests and not as a partnership. Once again seek the counsel of your tax advisors to understand the tax consequences and risks.
The primary reasons to hold property in a disregarded entity are protection of personal assets and reduced tax filing expense using Schedule C by the taxpayer. A subchapter S corporation is not considered a disregarded entity though the taxpayer is taxed on their personal return filing IRS Form 1120-S. A partnership is not a disregarded entity nor is a multi member limited liability company. A corporation is a separate entity from the taxpayer and is not a disregarded entity. The disregarded entity is ignored for federal and many state income tax purposes.
To learn more about what to consider when considering a 1031 exchange, download a free five page eBook on "1031 Exchange Taxpayer Checklist: 10 Issues" by clicking on the button below.