How 1031 Exchanges Work for LLC, Partnerships, Trusts, and Corporations with Partial Interest in the Property

**The information on this web page is provided for informational purposes only and should not be considered as legal, tax, financial or investment advice. Since each individual’s situation is unique, a qualified professional should be consulted before making financial decisions.**

Section 1031 Exchanges are viable as an individual, partnership, LLC, C corporation, or trust.

Substantial tax deferrals are possible with any of these ownership forms. Careful planning is especially important in fractional ownership situations. While partial interests add complexity, they’re no barrier to deferring taxes.

We’ll start with a basic, wide-ranging 1031 Exchange overview. Then explain how you can defer significant tax dollars by using this exchange as one of the aforementioned entities.

 

Universal Like Kind Exchange Ground Rules

Many Section 1031 exchange rules apply in general to all entity types involved here. Familiarity with them gives you a head start in understanding various scenarios. These rules are nonnegotiable, requiring your strict adherence at the risk of losing tax deferrals. Applicable to all entity forms, we’ll go over them just once here.

 

Replacement Property Value

For starters if you’re planning to replace only a portion of relinquished properties’ sale proceeds, do the math first. For maximum tax deferral gain, the value of like-kind replacement(s) must equal or exceed that of relinquished properties.

A rule of thumb: Exchangers reinvesting less than 50 percent of those proceeds in replacements are likely creating taxable boot that approximates all tax deferral. (Learn more about how boot is taxed in a 1031 exchange).

Their exchanges can proceed but for what purpose when it’s a wash, i.e. cost/saving net out? This and other cost/benefit considerations deserve your and any tax advisor’s attention up front. (Learn more about 1031 exchange costs).

 

Types of Entity

Owners of investment and business property may qualify as Exchangers for Section 1031 tax deferrals as:

  • Individuals
  • LLCs (single and multi-member)
  • Corporations (C or S)
  • Trusts
  • Partnerships (general or limited)
  • Other

Any of the above entities qualify for 1031 exchange at the entity level only. The entity’s property is relinquished and stays intact in return for purchases (replacements). A partial interest, e.g. a partnership interest can’t be exchanged.

Generally partial partnership, LLC, corporation, or trust interest are not considered a like-kind real property holding qualified to complete a 1031 tax-deferred exchange. IRC Section 1031(a)(2)(D) prohibits exchanges of partnership member interests.

However, a 100% partnership or LLC interest will qualify as like-kind real property when sold by the Exchanger.

Partnership may convert from a general to limited partnership or LLC during the exchange without impacting the 1031 Exchange.

 

Same Owner for Relinquished and Replacement Property

Both the relinquished and replacement properties must be owned and titled by the same party. A simple test: sellers’ and buyers’ tax returns (including IDs of the Exchangers) are the same. Individuals as sellers have the options to acquire as a disregarded entity [1], a single-member LLC or revocable trust.

Multi-member LLCs’ tax identification number will differ, thereby disqualifying them. Properties can be transferred to another entity after the exchange is complete. However, this may raise intent for holding issues. Section 1031(a)(1) reads:

(1) In general … No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.

Intent for holding real property is the IRS’ litmus test. Transactions that may muddy investment or trade/business intent carry risk. (More info at uscode.house.gov.)

[1] Disregarded entities are businesses separate from their owners but disregarded as being apart from those owners for federal tax purposes. That is, they’re all combined for tax purposes under one owner tax ID.

 

Drop and Swap Rules

Care is needed in a drop and swap 1031 exchange (covered in greater detail in the next section) where partnerships and multi-member LLCs drop down ownership to individual members.

The IRS requires disclosure when such a property distribution is made to another entity or to any partners as tenants in common. While the IRS hasn’t provided specific guidance, some advisors recommend a one-year holding period for a 1031 exchange property in support of the IRS’ intent for holding 1031 Exchange mandate.

 

1031-Qualifying Property Variations

30-Year Leasehold Interests

Fundamentally, investment property is like kind with any other property held for investment. The most common commercial real estate form of ownership is a fee simple title. Here the owner holds all rights, titles and interest in the real estate asset, including the right to dispose of the property (alienation).

While not as common, a leasehold interest transfer also qualifies. IRS regulations state that 30 years or longer leasehold interests are like kind with fee title real estate. Further, option renewal periods are to be considered. A 20-year initial term lease with three five-year options qualifies for 1031 exchange purposes.

You sell an office tower for while buying out an existing ranch lease of equal value. While only a 20-year lease, it has a 10-year extension. That 30-year leasehold interest qualifies as replacement property in completing a successful exchange. Any gain on the office tower sale is deferred.

 

Fractional Ownership Options

While ownership interests generally don’t qualify for 1031 exchanges, carveouts include:

  • Real Estate Tenants in Common,
  • Delaware Statutory Trust (DST),
  • Oil, gas, and mineral working interests may be exchanged for commercial real estate. Royalty interests won’t qualify.
  • Water and timber rights are generally treated in the same manner as oil, gas and mineral rights. Timber rights however are dictated by state law. Oregon classifies cut standing timber personal property while it’s real property in Georgia. When viewed as real property, an exchange for a fee simple may qualify.

 

Incidental Personal Property

Only real estate qualifies for the exchange after tax year 2018. Before the 2017 passage of the Tax Cuts and Jobs Act (TCJA) some exchanges of personal property qualified for a 1031 exchange. A TCJA transition rule permitted exchanges in 2018 when original properties were sold in 2018 or the replacement(s) acquired by year-end 2017.

Going forward, limited incidental personal property typically transferred along with real property can be included. Its total fair market value must represent 15% or less of the replacement(s) total value.

The 15% limitation is calculated by comparing the value of all of the incidental properties to the value of all of the replacement real properties acquired in the same exchange.

 

Drop and Swap 1031 Exchanges

What happens in a multi-member LLC, partnership, or trust with diverging member goals? One or more members e.g. want a 1031 Exchange while others call for a cash out.

A drop and swap exchange can accomplish this by changing fractional ownership interests. One or more members are allowed to drop out while the remaining member(s) conduct the 1031 Exchange.

A drop and swap transpires in several different ways with the following being the most common.

  • With the majority of members wanting to cash out minority taxpayers return their membership interest equivalent to their former membership interest. In return they then own a tenant in common (TIC) interest in the relinquished property. At closing, all TIC holders provide relinquished property buyers with deeds. Former member(s) can direct their proceeds share to a qualified intermediary.
  • With the majority of members wanting to complete exchanges, minority members just want to cash out. By dropping applicable property percentage amounts to the existing members, the 1031 Exchange is completed at the entity. Former members pay the taxes due as they cash out.

Drop and swaps should be completed well in advance of the Exchange. Selling relinquished properties starts the 1031 Exchange process. Marketing can’t start until the drop and swap completes the ownership changes.

Caution: The IRS has not formerly approved this transaction and will monitor it. Schedule B of Form 1065 asks whether property has been transferred from:

  • multi-member LLCs to other entities or
  • partners in a tenancy in common.

Although the IRS provides no specific holding period, one year prior to or post acquisition is often recommended. Again, this lends support for meeting the intent for holding assets qualifier.

Note: Corporations aren’t eligible to do a drop and swap.

 

Can a Multi-Member LLC Do a 1031 Exchange?

Yes, but that same LLC name must be on titles for both the relinquished and replacement properties. The exchange must be on the entity level, i.e. the entire property relinquished stays intact with proceeds used to purchase replacement(s).

In a community property state, a husband and wife who are the sole members of a two-member LLC may be considered a single-member disregarded LLC for Federal tax purposes.

 

Accommodating Multi-Member LLC Members with Differing Objectives

Certain members may want to invest in a different replacement(s) or cash out while paying their own taxes. Still other LLC members want a 1031 exchange.

Discussed in the previous section, a drop and swap exchange provides a solution. It changes the ownership interest to allow one or more members to drop out while the remaining member(s) conduct the 1031 Exchange.

Again, be mindful that the IRS provides no specific lapse time. A one year holding period following the drop and swap is often recommended.

 

Can a Partnership Do a 1031 Exchange?

Yes, partnership entities can exchange but again IRC Section 1031(a)(2)(D) prohibits partnership interests from a like kind exchange.

First, whether it’s a true partnership must be established. Sometimes shared property ownership may be misconstrued as a partnership. Individual investors hold undivided interest as co-owners filing no partnership tax returns.

Assured they’re partnerships, Exchangers can’t buy into or sell partnership interests in a qualified 1031 Exchange. With an entire partnership, the Partnership Agreement should state that the intent for holding the property is investment or use in a trade/business. This is because there’s always the risk the IRS will question the exchange’s validity.

 

Accommodating Partnership Members with Differing Objectives

Again, one option is to dissolve the partnership prior to the sale. Then distribute property tenants in common interests to individual partners (the drop in a drop and swap). Then those members deed the property to relinquished properties’ buyers.

Some former partners exchange their interests for replacements (the swap in a drop and swap) into replacement(s). Remaining members on cashing out their share of sale proceeds will pay taxes on any gain.

Another possibility has partnerships stay intact with relinquished properties exchanged for replacement(s). Then the 1031 exchange property can be refinanced and the proceeds distributed to the partner who wants to cash out.

Or again staying intact, partnerships could exchange relinquished properties for cash and installment notes. Then with proceeds buy replacement(s) and distribute installment notes to partners wishing to withdraw from the partnership.

Still another option with a subchapter K election out under IRC §761 has partners selling their undivided interest. Other partners exchange their tenancy-in-common interest for replacement(s).

Timing may become an issue with an election out undertaken just before relinquished property closings. The question arises whether such undivided interests were owned long enough to establish intent to hold.

In most cases when challenging the validity of a Sec. 1031 Exchange, the IRS typical argue:

  • partners weren’t holding property for qualified use,
  • step transaction doctrine, i.e. a specific series of tests that attempt to determine the substance (over form) of a transaction, and/or
  • partners have cotenancy in the property, i.e. undivided interests with no rights to transfer their interests outside of the partnership.

 

1031 Exchange and Partnership Buyout

Partnerships could:

  • buy departing partners’ interest out with relinquished properties sale proceeds. This would create cash boot assigned to the partnership, however. It would have to allocate the resulting gain among all the partners.
  • Or undertake a partnership installment note (PIN) transaction, causing the resulting gain to be recognized by the departing partners only.

In a PIN transaction – instead of receiving cash – the partnership receives an installment note. It’s in consideration for their partnership interests. It covers the amount needed to buy out the departed partners’ interest.

At least one note payment is to be received in the year following the exchange. Then the gain associated with that note is taxed under the Section 453[2] installment method. It’s recognized only when the actual payments are received by the departed partner(s).

Alert: depreciation recapture taxes are not deferred.

[2] Under Section 453, Capital Gains Tax deferrals are permitted [a] when accepting a carryback promissory note or [b] periodic annuity payments are received. In the first instance, the seller defers Capital Gains income tax recognition until principal payments are received. In the latter, deferred capital gains amounts are recognized pro rata on principal payments as received.

 

Can a Corporation Do a 1031 Exchange?

General Rules

Yes, but:

  • Corporate stock does not qualify for 1031 exchange treatment under exchange rules.
  • Corporations – not Individual shareholders – must complete the exchange as an entity. Also, corporations must hold title to replacement(s) if relinquished properties are titled to them.

This raises an issue when replacement(s) are needed by an affiliate different from the one owning the relinquished property. Any attempt to transfer property titles to the other affiliate is problematic. Once again facing 1031’s intent for holding investment or trade/business purpose test. Or the title-holding affiliate could lease long-term the property back to the other affiliate.

Also problematic is a corporation that has located replacement(s) prior to selling its relinquished property. Then, a 1031 Reverse Exchange may be the solution. Named Reverse because this exchange calls for acquiring replacement(s) first. Replacement(s) are held by a 1031 Exchange accommodator (Qualified Intermediary) until the relinquished property is sold.

 

Accommodating Corporate Shareholders with Differing Objectives

Corporations have the option to buy back shareholders’ stock of those who want to cash out. Those shareholders pay capital gains tax at the individual level. Remaining shareholders defer all capital gains taxes when the corporation completes the 1031 Exchange.

 

Can a Trust Do a 1031 Exchange?

Yes, Exchangers can utilize trusts as the entity acquiring replacement(s) on their behalf. There are three parties in a typical trust:

  • Grantors create the trust by transferring property to the trustee (typically pursuant to a written trust agreement),
  • Trustees hold legal title for the benefit of the trust beneficiaries, assuming responsibility for administering the trust, and
  • Beneficiaries receive the real property assets after the passing of the Grantor.

In the three types of trusts we’ll cover here the taxpayer is the:

  • Grantor in revocable trusts, and
  • Trust doing the exchange in irrevocable trusts, and
  • Trustee in land trusts.

Revocable (Living) Trusts are created by Grantors who draft trust agreements transferring property to trustees. Grantors and trustees are often the same person initially.

These trusts are considered disregarded entities allowing Exchangers to file single returns. They’ll use their own tax identification number rather than separate EINs for the Trust. Continuity of Investment is upheld because Exchangers are the same taxpayer.

They file no tax returns with the trust Grantors reporting all activity. While Grantors are living, their trusts can be amended or revoked. As the taxpayer they can:

  • sell their relinquished property with the Trust on the title and
  • acquire their replacement property as an individual or a single member LLC.

Irrevocable Trusts cannot be modified or amended by Grantors once created. Grantors revoke all asset ownership rights now held by the Trust. These trusts are assigned unique tax identification numbers. To satisfy the same taxpayer requirement, Exchangers selling real property must acquire replacement property in the same trust. In a 1031 exchange, the Irrevocable trust is considered the taxpayer.

Land Trusts are often referred to as Illinois Land Trusts or Title Holding Trusts. Trustees can utilize a 1031 exchange as other taxpayers do. Owners often favor the privacy and protection from creditors that trusts afford. Who owns the property is a secret. These features are attractive to some land holders.

Trustees are the Exchangers who retain a Qualified Intermediary (also called 1031 exchange companies) to sell relinquished properties. Typically they also acquire the replacement property through the QI. Alternatively trustees create a disregarded entity, e.g. a wholly owned LLC to acquire the replacement(s).

There can be no partnership agreement with interest-holding beneficiaries. Interests are not exchange eligible. With irrevocable trusts – once properties are conveyed to beneficiaries – no changes are permissible without the beneficiary’s approval.

Delaware Statutory Trusts (DSTs) Quite popular today, they facilitate ownership of property by multiple investors. Trustees hold legal title to a property while investors purchase beneficial interests in the trust. The IRS has determined that with the very limited powers of trustees:

  • owners of the beneficial interests are treated as grantors of a grantor trust and
  • for tax purposes own fractional interests in the underlying property held by the trust.

Therefore, a beneficial interest in a DST that owns real property is of like-kind to a fee interest in real property. As such, Delaware Statutory Trusts (DSTs) are 1031 Exchange eligible.

That’s it for our 1031 overview and how to defer taxes on investment property sales. It’s quite possible even when your partnership interest represents only fractional ownership.

Often though it’s an exceedingly complex process that few investors are equipped to deal with effectively. Seeking expert counsel is almost a given absent investors who themselves are 1031 Exchange experts.

 

How to Ensure Your Exchange Is Legal and Safe?

Unless you are conducting a simultaneous exchange that doesn’t involve boot, you must use services of a qualified intermediary.

A professional, competent, and experienced 1031 exchange company with income tax experts on the team will advise you on the options you have to minimize your boot while getting the most of your relinquished property value.

They will ensure that the procedure is completed legally, in compliance with all IRS rules.

PropertyCashin is an all-in-one platform for commercial real estate investors that maintains relationships with top-rated 1031 exchange firms in all locations of the USA. To get connected with the best professionals and have your exchange processed safely and effectively, fill out the form below.

About the Author
Sam McGrath

As the Lead Commercial Real Estate Analyst at PropertyCashin, Sam McGrath is responsible for the company’s national sales strategy. Prior to his position with the company, Sam served as a Surface Warfare Officer in the United States Navy. Further, Sam was the National Recruitment Manager at Maxim where he expanded the Maxim healthcare brand nationally. He has over 8 years of experience in creative real estate investing. In addition, Sam has bought and sold commercial and residential property in over 42 states. Sam has a bachelor’s degree in business administration and marketing from Texas State University.

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