1031 Review – It’s been a long time since you saw one

» Articles » Accounting Articles » Article

August 22, 2013


I. Introduction

Although this is an advanced strategies course about 1031 exchanges in today’s market, it is probably helpful to review the rules and structures of 1031 exchanges.

 
II. 1031 Review – It’s been a long time since you saw one…

Section 1031 is an exception to the requirement that gain or loss be recognized on the disposition of property. Section 1031 provides that:

No gain or loss shall be recognized on the exchange of property held for the productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for theproductive use in a trade or business or for investment (emphasis added).

Continue reading below

FREE Accounting Training from Lorman

Lorman has over 37 years of professional training experience.
Join us for a special report and level up your Accounting knowledge!

Tax Aspects of Operating a Partnership-Taxed Organization
Presented by Langdon T. Owen Jr.

Learn More

Before discussing the requirements of the statute, it is important to know the difference between “realized” and “recognized” gain. Realized gain represents the potential taxable gain; whereas recognized gain is the actual gain subject to tax. Accordingly, the word “recognized” in the first line of the statute could be substituted with the word “taxed”. A plain language interpretation of the statute would be: Any gain realized on an exchange of like-kind property will not be taxed until the investor “cashes out” of their investment (no longer owns like-kind property). This distinction is important to understand why a person who exchanges real property for like-kind real property and cash has a valid exchange and just pays tax on the cash (the non like-kind property) received.

There are three statutory requirements in section 1031. First, there must be an exchange; second, both the relinquished and replacement properties must be “held for” a qualified use; and third, both the relinquished and replacement properties must be like-kind.

A. Statutory Requirements

1.  Exchange Requirement

The dictionary defines an exchange as being the act of substituting one thing in return for another; a reciprocal giving and receiving. The exchange requirement of section 1031 can be satisfied in two ways. There can be a direct trade of properties between two parties; or more commonly in today’s market, the exchange can be created in accordance with the 1031 regulations using a

Qualified Intermediary (QI) to facilitate the exchange. The “swapping” of properties is simple in concept but much more difficult in reality because it requires a balancing of value of the properties being swapped as well as finding parties who want each other’s property.

Using a Qualified Intermediary to satisfy the exchange requirement is much easier to achieve since the Exchanger can sell the Relinquished Property to anybody (for cash) and buy their Replacement Property from anybody (for cash).

It just has to be structured in accordance with 1031 regulations. The diagram below outlines the process.

Diagram 2.1

To comply with the regulations, the Qualified Intermediary must enter into an Exchange Agreement with the Exchanger and assign into the sale contract (with the buyer of the relinquished property) before the Relinquished Property is transferred. At the closing provided for in the sale contract, the property is deeded to the buyer (directly from the Exchanger) and the settlement agent pays off any loan and any other costs associated with the transfer, including real estate commissions and transfers the net sales proceeds to the Qualified

Intermediary (who previously assigned into the sale contract as seller); the net sale proceeds are called “exchange funds” when in possession of the Qualified Intermediary.

The Exchanger, with the help of their real estate agent, locates their Replacement Property and enters into a contract to purchase it. The Qualified Intermediary assigns into this contract thus “stepping into the shoes” of the Exchanger. On the date of closing, the Qualified Intermediary pays the exchange funds to the seller of the Replacement Property and has that party deed the property directly to the Exchanger, thereby completing the exchange.

The exchange requirement is satisfied through the use of the Exchange Agreement and the assignments of the purchase and sale agreements. Through the Exchange Agreement the QI agrees to acquire the Relinquished Property from the Exchanger and it transfers the property to the Buyer through the sale contract it assigned into. Similarly, the Exchange Agreement provides that the Qualified Intermediary will use the exchange funds to acquire the Replacement Property and transfer it to the Exchanger by means of a direct deed from the Seller. In accordance with the 1031 regulations the Qualified Intermediary is deemed to have received the Relinquished Property from the Exchanger and have transferred the Replacement Property to the Exchanger; thereby satisfying the exchange requirement. This concept is visually depicted through the arrows located within the circle in Diagram 2.1.

To avoid the unnecessary imposition of transfer taxes, recording fees as well as potential clouds on title, direct deeding between the parties is permitted instead of requiring sequential deeding into and out of the Qualified Intermediary

a. Evaluating a Qualified Intermediary

When selecting Qualified Intermediary, it is important to consider a number of factors including: the security of the exchange funds; the financial strength of the Qualified Intermediary as well as the soundness of its business practices; whether it complies with the statute and IRS regulations; and whether its employees are knowledgeable and competent. With regard to security, the Exchanger should determine whether there exists a performance guarantee (of the Qualified Intermediary) from a financially stable third party; whether it has a significant Fidelity Bond (crime insurance); whether it has a significant amount of Errors & Omission Insurance; and how the exchange funds will be held and/or invested. With regard to financial strength and the possession of sound business practices, the Exchanger should ascertain whether they undergo 3rd party audits; whether they require dual signatures on disbursements of exchange funds; and whether they have a procedure that requires a written authorization by the Exchanger before exchange funds can be disbursed. Finally, it is important to know whether the Qualified Intermediary has attorneys, accountants and/or Certified Exchange Specialists (CES®) on staff as well as whether they comply with the regulations and legal requirements for a 1031 exchange.

2. Qualified Use Requirement

Both the relinquished and replacement properties must be “held for” a qualified use. A qualified use can be property held for investment or property held for the productive use in a trade or business. An example of “investment property” for 1031 purposes would be to own unimproved real estate for future appreciation by factors unrelated to your actions (time, completion of a new highway, expansion of a city in that direction, etc.). Examples of property held for the productive use in a trade or business would be a single family dwelling that is being rented, a strip center (business of renting and operating) or a farm or ranch that is operated.

It does not include property that is held primarily for sale. An example of this would be property that was purchased with the primary intent of fixing it up and selling it for a profit. This type of property would be considered to be inventory and accordingly any gain would be taxed as ordinary income.

The Exchanger’s purpose for holding the relinquished and Replacement Property is determined when the exchange takes place. Whether it is held for a qualifying purpose is a question of fact; the burden of proving is the Exchangers, if they are audited. Accordingly, the relevant question is whether the Exchanger acquired the property primarily to sell it or acquired the property primarily to operate it or have it for a “long term hold”.

3. Like-kind Requirement

The relinquished and Replacement Property must be like-kind to qualify for exchange treatment under section 1031. The term like-kind refers to the nature or character of the property not its grade or quality. For this reason nearly all real property is like-kind to each other. The following items are all considered like-kind and can be exchanged for each other: vacant land, commercial buildings (office, industrial or warehouse), ranches, farms, rental homes, apartment buildings, tenant–in-common interests as well as leases of 30 years or more (including options).

Personal property which is held for investment or business use is also eligible for a 1031 exchange and can be exchanged for property of like-kind. However, the like-kind property standard has been interpreted more narrowly in the case of exchanges of personal property than in exchanges of real property. For example, while undeveloped land may be exchanged for an office building, a car may not be exchanged for a truck. Under the Regulations for personal property, depreciable tangible personal property which is being held for productive use in a trade or business is considered to be exchanged for like-kind property if it is exchanged for property that is either like-kind or like class.

Although the like-kind standard is narrower for personal property exchanges than real property exchanges, personal property exchanges are important especially in transactions involving the sale of an ongoing business. Depreciable tangible personal property is like class if it is within the same “General Asset Class” or within the same “Product Class.” This is a safe harbor which is provided by the 1031 regulations. The “safe harbor” means that if two items are in the same General Asset Class or Product Class, they are considered to be “like-kind” for a 1031 exchange; this fact will not be challenged by the IRS in the event of an audit of their exchange Property within a General Asset Class consists of depreciable tangible personal property described in Revenue Procedure 87-56. The General Asset Classes are as follows:

1)    Office furniture, fixtures and equipment (asset class 00.11);

2)    Information systems (computers and peripheral equipment) (00.12);

3)    Data-handling equipment, except computers (00.13);

4)    Airplanes and helicopters (air frames and engines), except those used in commercial or contract carrying of passengers or freight (00.21);

5)    Automobiles and taxis (00.22);

6)    Buses (00.23);

7)    Light general-purpose trucks (00.241);

8)    Heavy general-purpose trucks (00.242);

9)    Railroad cars and locomotives, except those owned by rail road transportation companies (00.25);

10) Tractor units for use over the road (00.26);

11) Trailer and trailer-mounted containers (00.27);

12) Vessels, barges, tugs and similar water transportation equipment, except those used in marine construction (00.28); and

13)  Industrial steam and electric generation and/or distribution systems (00.4).

The other way to determine if two items are like-class is found in the six digit product classes within Sectors 31, 32 and 33 (pertaining to manufacturing industries) of the North American Industry Classification System (NAICS). A copy of the NAICS is available at www.census.gov/naics. If two items are in the same General Asset Class or Product Class then they are considered “like-kind” for 1031 purposes.

However, it is possible for two items to be “like-kind” even if they are in not “like class”. This occurs when the differences do not rise to the level of a difference in nature and character, but merely a difference in grade and quality. For example, the IRS has ruled that the differences between an automobile and a passenger van or an SUV did not rise to the level of a difference in nature or character but are merely a difference in grade or quality. However, a truck (such as a commercial utility vehicle used by a telephone company) is different in nature and character than an automobile.

As a result, the first determination is whether the two items are like class. If so, the inquiry ends since they are considered to be “like-kind” for 1031 exchange purposes. If an item is in more than one Product Class, it may be exchanged for an item in either Product Class. For example, plows and tractors are listed in NAICS Code 333111 (Farm Machinery) and NAICS Code 333120 (Construction

Machinery). Accordingly, the Exchanger can choose the class that is most advantageous. Due to the fact that the determination of what is like-kind is more complicated in personal property exchanges than real property exchanges, it is strongly advised that the Exchanger’s accountant is consulted to assist with “lining up” like-kind assets.

B. Statutory Timelines

1. Identification and Exchange Periods

The identification period in a 1031 exchange begins on the date the Exchanger transfers the Relinquished Property and ends at midnight on the 45th day thereafter. The exchange period, also called the completion period, begins on the same day as the identification period (the date the Exchanger transfers the relinquished property) and ends on the earlier of either the 180th day thereafter or the due date (including extension) for the Exchanger’s tax return for the taxable year in which the transfer of the Relinquished Property occurred.

It should be noted that the counting of the 45 and 180 periods begins on the day after the relinquished is transferred not on the day of transfer itself. Accordingly, the identification and exchange periods are a full 45 and 180 days, respectively. As such the total exchange period is 180 days and the 45 day identification period is included in that period; it is not 45 days plus 180 days as many individuals believe. It should also be noted that the time periods are calendar days, not business days. Accordingly, the identification and exchange periods will count weekends and holidays. If the 45th day or the 180th day falls on a weekend or holiday it will not be extended until the next business day; for that reason, Exchanger’s need to be aware of the expiration of the identification and exchange periods and plan accordingly.

2. Identification Rules

All Replacement Property must be identified in a writing; which is signed by the Exchanger; and which unambiguously identifies the property. The identification must also be delivered; within the 45-day identification to a qualified person (usually this is the Qualified Intermediary). Only property which is properly identified is eligible to be acquired as replacement property. Accordingly, to be considered “like-kind” to the relinquished property, Replacement Property must be properly identified during the identification period and acquired during the exchange period.

Exchangers have the flexibility of identifying more than one property as the Replacement Property in their exchange and acquire any or all of the properties which are properly identified. The options for identification are:

 a.    Three Property Rule - The Exchanger may identify, as potentialreplacement property, any three (3) properties without regard to their fair market value;

 
b.    200% Rule – The Exchanger may identify, as potential replacementproperty, any number of properties; as long as their aggregate fair market value (as of the end of the identification period) does not exceed 200% (two times) of the aggregate value of all the relinquished properties as of their transfer; or

 c.    95% Rule (Exception) – If the Exchanger has identified moreproperties than are permitted under either of the rules above, t

Exchanger must receive, by the end of the exchange period, Replacement Property which has a fair market value of at least 95% of the aggregate value of all the properties identified.

The rules must be strictly adhered to. For example, if an Exchanger identifies more than 200% of the value of all relinquished properties and fails to satisfy the 95% rule, it is deemed that they identified no properties. The Exchanger is also able to revoke identifications during the identification period. Revoking an identification is the opposite of making one; the revocation must be in a writing signed by the Exchanger, unambiguously identify the property being revoked and be delivered to the party to whom the original identification was made. Once the identification ends (at midnight on the 45th day) no further property may be identified or revoked.

C. Basis

The term “basis” is the cost of a property for tax purposes. When a property is initially purchased it has a purchase money basis; which is the price paid for the property plus acquisition costs. During each year of ownership, the basis may change resulting in an adjusted basis. The basis is increased by any capital improvements to the property and reduced by depreciation taken.

In a 1031 exchange, because taxes are deferred the Exchanger has what is called a “carry-over” basis in the Replacement Property (not a “purchase money” basis). The basis carried over to the Replacement Property is the purchase price of the Replacement Property LESS any gain deferred in the exchange PLUS any gain recognized in the exchange and acquisition costs of the replacement property. Stated in simpler terms, the basis from the Relinquished Property is transferred to (carried-over to) the replacement property. Although the calculation used by accountants is significantly more complicated than the sentence above, it conveys the primary concept of the basis being carried over.

Knowing the basis of a property is very important especially if there has been considerable depreciation. Taxes are paid on the difference between the sales price and the adjusted tax basis (not the sales price minus the equity).

Accordingly, a seller may have to pay taxes even if they are selling the property for less than they purchased it for. For example, let’s assume that a printer sells or “trades-in” a printing press for $90,000 that was purchased six years earlier for $300,000. Since the printing press is depreciated over a five year period, it has an adjusted basis of zero when it is sold. Unless the printer does a 1031 exchange he will have to pay taxes on the $90,000 gain ($90,000 sale price minus $0 adjusted tax basis).

Sellers should always discuss their individual situation with their tax advisor to determine whether a 1031 exchange is advisable to defer capital gain and depreciation recapture taxes.

D. Boot

The term boot refers to non-like-kind property received in an exchange. Usually boot is in the form of cash, an installment note, debt relief or personal property and is valued to be the “fair market value” of the non-like-kind property received.

It is important to understand that the receipt of boot does not disqualify the exchange; it merely introduces a taxable gain into the transaction. Accordingly, any non-like-kind property received in an exchange will be taxed, up to the amount of realized gain from the sale of the relinquished property.

To avoid having boot, the Exchanger should follow three rules:

Purchase like-kind Replacement Property of equal or greater value than the Relinquished Property (buy equal or greater in value);
Reinvest all of the net equity (exchange funds) from the sale of the Relinquished Property into the Replacement Property (spend all of the equity); and Obtain equal or greater on the Replacement Property than was paid off or assumed on the Relinquished Property (replace the debt). As a practical matter, satisfying the first two rules; buying equal or greater value property andreinvesting all of the exchange funds, will result in the debt requirement being satisfied.

There is an important exception to the debt requirement which can be helpful when your clients can’t or don’t want to have as much debt on the replacement property. A reduction in debt on the Replacement Property can be offset with additional cash from the Exchanger. For example, let’s assume that your client has a loan of $500,000 on the Relinquished Property (which will be paid off) and they only want a loan of $450,000 on the replacement property. They will still have a fully tax deferred exchange if they offset the $50,000 of debt reduction by investing an additional $50,000 of equity in the replacement property.

III.   Partnership and LLC Issues A. Partnership Issues

Exchanges of partnership interests are ineligible for non-recognition treatment under IRC §1031 as it was amended by the Tax Reform Act of 1984 to add §1031(a)(2)(D). That provision provides that §1031 does not apply to an exchange of interests in a partnership regardless of whether the interests exchanged are general or limited partnership interests or are interests in the same partnership or in different partnerships. As a result, a taxpayer cannot exchange an interest in ABC Partnership for an interest in XYZ Partnership, even if both partnerships own the same kind of property. It is important to note that a partnership interest is a personal property right, which is not like-kind to the real property which may be owned by a partnership.

A partnership, however, may exchange real and/or personal property under §1031, as long as the partnership meets the requirements that apply to all exchange transactions (i.e., both the relinquished and replacement properties will be held for investment or business purposes, etc.).

An important issue when addressing exchanges involving partnerships is to determine the individual investment objectives of the partners. When the entire partnership wants to structure a tax deferred exchange, it is clear that thetransaction can qualify under §1031. Problems arise, however, when one or more of the individual partners have different investment objectives.

The  most  commonly  asked  question  is  “Can  a  valid  exchange  still  be structured if one of the partners drops out of the partnership?”  Often one or more of the partners desire to withdraw from the partnership and receive cash or other property in return for their partnership interest. Most partnership issues can be resolved with advanced planning. Accordingly, investors in partnerships that may want to separate in future investments (and/or sell for cash) should plan ahead and speak to their tax advisors.

1.    Distributing an undivided interest: Although there are manystructures, many practitioners believe that there is less risk of an exchange being disallowed on audit if the partners desiring to receive cash on the sale of the Relinquished Property receive a distribution of their partnership interest in the form of an undivided interest in the Relinquished Property prior to the closing of the sale. Then, as long as there are at least two remaining partners who owned more than 50% of the partnership before the redemption (to avoid a technical termination of the partnership), this leaves the partnership in existence to accomplish the 1031 exchange. At the closing, the surviving partnership and each of the former partners convey their respective interests in the relinquished property, with the former partners receiving cash, and the Qualified Intermediary receiving the net proceeds due the partnership to enable the partnership to complete the exchange when it locates replacement property. Completing the redemption of the cashing-out partner as far in advance of the sale, and if possible, prior to the execution of the contract of sale for the relinquished property, is highly desirable.

2.    Liquidate partnership and distribute tenancy-in-common interests: Another possible solution is to liquidate the partnership priorto the exchange and distribute to each “partner” a tenancy-in-common interest in the real property with the other former partners. It is advisable to transfer ownership to the individual Exchangers as far in advance of the exchange as possible. If a distribution or dissolution occurs shortly prior to the exchange (or shortly after the exchange), the key issue is whether the Relinquished Property (or replacement property) was “held for productive use in a trade or business or for investment purposes.” This “qualified use” requirement must be met for the exchange to be considered to be valid. The strategy of distributing an undivided interest to the “cash-out” partners prior to sale, thus allowing the partnership to accomplish the exchange, generally avoids the qualified use issue since the partnership remains in existence and completes the 1031 exchange.

3.    "Drop and Swap" and "Swap and Drop": The IRS and various statetaxing authorities have gotten good at identifying and disallowing "Drop and Swap" transactions (distributing the Relinquished Property to the partners shortly before the exchange) as well as "Swap and Drop" transactions (distributing the replacement properties to the partners shortly after the exchange). As a result of recent developments, a taxpayer who engages in a "Drop and Swap" or a "Swap and Drop" transaction will likely have their 1031 exchange disallowed in an audit and be liable for taxes, interest and penalties. Accordingly, entering into one of these types of transactions is considered risky and most tax advisors caution against it.

If distributing an undivided interest of the partnership property or dissolving the partnership well in advance of the exchange is not possible, the partners who want to exchange may want to consider one of the following: purchase the interest of a retiring partner; having the partnership sell the Relinquished Property for cash and an installment note; or a partnership division.

4.    Purchase the interest of a retiring partner: This technique can beimplemented before or after a 1031 exchange. If it is done before the exchange, the partners who want to exchange add equity which is used to buy out the retiring partner or partners. Once this occurs, the partnership performs a 1031 exchange. In addition, the partnership must acquire Replacement Property which has the same or greater value compared to the Relinquished Property to fully defer taxes. If it is done after the exchange, the partnership secures financing on the Replacement Property that it received in the exchange and buys out the retiring partner or partners.

5.    Selling the Relinquished Property for cash and an installment note: This method involves having the buyer of the Relinquished

Property pay with cash and an installment note; the cash is used by the partnership in the exchange and the retiring partner receives the installment note in redemption of his or her partnership interest. If at least one true payment is paid in the following tax year, it should be considered a valid installment note and receive installment sale treatment under I.R.C. §453. Most tax advisors suggest that at least 5% of the total payments of the note be made in the next tax year.

Both of the above techniques (as well as distributing an undivided interest to a retiring partner) require that after the buy-out or redemption, there must be at least two remaining partners who owned more than 50% of the partnership. This is to ensure that the partnership continues to exist for the satisfaction of the "held for" requirement.

6.    Partnership Division: This technique can be done before, after andpossibly during an exchange. Using the partnership division rules of I.R.C. §708(b) (2), a partnership can divide into two or more partnerships. The new partnerships must each contain partners, who together, owned more than 50% of the original partnership. If this is done, the new partnerships are deemed to be continuations of the original partnership (thereby satisfying the "held for" requirement). For example, let's assume that a partnership is comprised of John and Jeff (each owns a 50% interest) who no longer want to be partners. John- Jeff  Partnership  would  divide  into  two  partnerships,  John-Jeff  Partnership I (John owns a 99% interest and Jeff owns a 1% interest) and John-Jeff Partnership II (John owns a 1% interest and Jeff owns a 99% interest). If the division is done after the exchange is completed, the partnership can distribute the replacement properties to the resulting partnerships. As a result, John has a 99% interest in the partnership which owns the property he wanted and Jeff owns a 99% interest in the partnership that owns the property that he wanted. After one to two years, John and Jeff could dissolve the partnerships and completely separate, provided their tax advisor was comfortable with that timing. Although partnership division may not be suitable for partners who want to immediately completely separate their holdings, it provides a way to achieve this over a period of time and still comply with the "held for" requirement of §1031.

B. LLC Issues

Because of advantageous tax treatment combined with liability protection, limited liability companies (LLCs) have become a preferred way to own real estate In the United States. By understanding their structure, they can also be used to provide flexibility in complying with the requirements of a 1031 exchange. All 50 states have enacted laws permitting the formation of LLCs, including single member LLCs.

LLCs are formed in accordance with the laws in the state of their creation. Although they are separate entities (from their owners and/or managers) for liability purposes they may be disregarded entities for federal tax purposes. That means that although the member of the LLC is insulated from liability from LLC activities, he or she is considered to be the "taxpayer" for federal tax purposes. This creates planning opportunities for 1031 exchanges.

For federal tax purposes, an LLC is characterized one of three ways: as asoleproprietorship (which reports income on a Schedule D to Form 1040); a partnership

(which reports income on Form 1065); or a corporation (which reports income on Form 1120 or Form 1120-S). If the LLC files no election with the IRS to be treated differently, by default, a single member LLC is considered to be a sole proprietorship and therefore disregarded from its member for federal tax purposes.

Similarly an LLC with two or more members that files no election with the IRS is considered to be a partnership for federal tax purposes. An exception to this rule is provided by Revenue Procedure 2002-69, which holds that the IRS will consider an LLC to be a disregarded entity if it is owned solely by a husband and wife as community property. This only applies in the nine "community property states" which are: Louisiana; Texas; New Mexico; Arizona; California; Nevada; Washington;  Idaho; and Wisconsin. The other 41 states are considered to be "common law states" and in those states, an LLC owned solely by husband and wife would be considered to be a partnership for federal tax purposes.

In addition to the "default rules" referenced above, an LLC (either single member or multi-member) can make an election with the IRS to be treated as a corporation for tax purposes. If desired, the LLC can make a further election to be treated as an S Corporation instead of a C Corporation. In summary, an LLC with only one owner will be classified as a disregarded entity or a corporation; whereas an entity with two or more members will be classified as a partnership or a corporation (unless it is a husband and wife LLC in a community property state).

The use of disregarded entities can be very helpful in resolving challenges which may be presented by the vesting requirements for a valid 1031 exchange; that is the Replacement Property must be acquired by the same taxpayer that disposed of the relinquished property. Although there are other disregarded entities such as Delaware business trusts, Massachusetts nominee trusts, Illinois land trusts and grantor trusts; the use of single member LLCs is probably the most common in connection with 1031 exchanges.

Treasury regulation §301.7701-(3)(b)(1) provides that single member LLCs that acquire property are ignored for federal tax purposes and that the member is treated as the direct owner of the property. In addition, the IRS has issued a number of Private Letter Rulings that held that the disposition of the Relinquished Property (or acquisition of the replacement property) by a disregarded entity of the taxpayer will be treated for purposes of §1031 as if the taxpayer had disposed of the property.

The key to understanding the use of disregarded entities in a 1031 exchange context is the identification of the taxpayer. To have a valid 1031 exchange, the same taxpayer must sell the Relinquished Property and acquire the replacement property.

For example, assume an investor wants to sell an investment property which is owned individually; however, he wants to acquire the Replacement Property in an LLC to protect himself from liability. Because of the disregarded treatment of single member LLCs this is not a problem. He can sell the property he owns personally and acquire the Replacement Property in a single member LLC (in which he is the single member). Frequently lenders require that the Replacement Property be purchased in a "bankruptcy remote" entity. In addition, an investor may be concerned about contingent liability relating to the selling entity and does not want take a chance that the Replacement Property might become a target in a future judgment. In both of these situations, a disregarded single member LLC is very useful. A new single member LLC is created to acquire the Replacement Property and the entity that owned the Relinquished Property (individual, partnership, corporation, LLC, etc.) is made the single member of it.

Finally, it should be noted that the IRS has ruled on numerous occasions that the acquisition of a disregarded entity holding the Replacement Property is treated (for 1031 purposes) as the acquisition of the replacement property. This is helpful to avoid paying the transfer tax twice in some states especially in 1031 exchanges which involve parking arrangements. For example, let's assume the Replacement Property is being held by an exchange accommodation titleholder (EAT) in a disregarded single member LLC. Acquiring the LLC satisfies the exchange and will not trigger the double payment of transfer taxes in many states; however the deeding from the LLC to the Exchanger would cause the double payment of transfer taxes which is triggered by the recording of the deed.

IV.       Legally” extending” the 1031 timelines

A. Recent Developments in Related Party Exchanges

In 2010 the IRS issued PLR201048025 which didn’t receive much attention because it was consistent with many prior PLRs. However, it provides potential planning opportunities to your clients that may desire to redistribute property ownership among related entities. This PLR involved a daisy chain of three related party exchanges.

In Exchange #1, the taxpayer (TP) sold a property to an unrelated party and acquired Replacement Property from a related party (RP1). In Exchange #2, RP1 sold Relinquished Property to TP (in exchange #1) and acquired Replacement Property from a related party (RP2). Lastly in Exchange #3, RP2 sold Relinquished Property to RP1 (in Exchange #2) and acquired Replacement Property from an unrelated party.

Replacement Property can be acquired from a related party if that related party also does an exchange. Since the IRS considers related parties to essentially be alter egos, the service presumably collapsed the intermediate related party exchanges and came to the following summary: TP was selling to an unrelated party and acquiring the replacement property from an unrelated party.

Although PLRs can only be relied upon by the party who obtained it many tax advisors review the rulings in PLRs to estimate how the IRS might rule in a certain fact pattern. As a result, this PLR may be helpful to REITS and or entities that own multiple properties to restructure ownership among related parties. In addition, more aggressive advisors and their clients may use this as guidance of acquiring property from a related entity if they are having difficulty identifying suitable replacement property.

 B.      Satisfying the Exchange Without Acquiring Fee Title

What do you do if your client’s 180-day deadline is approaching but they need a little more time to close on the loan needed to buy the Replacement Property?

1. Acquiring a Leasehold Interest

If no loan was paid off on the sale of the Relinquished Property then no debt needs to be replaced on the acquisition of the Replacement Property.

In this situation, the Exchanger can purchase a leasehold interest in the property of 30 years or more including options (considered like-kind to fee ownership). In addition, the Exchanger could purchase an option to buy the fee interest which will be exercised when the loan closes.

Exchange funds can only be used to acquire the option or the right to lease. They cannot be used to prepay any lease payments.

2.  Using Seller Carry Back Financing

If a loan was paid off on the sale of the Relinquished Property acquiring a leasehold interest will not work because the debt must be replaced. In this scenario, the Replacement Property must be transferred to the Exchanger before the end of the 180-day period using seller financing on a short term basis. The lender should be advised of this interim financing because their loan is now a refinance, not a purchase money loan.

As stated earlier, these are ways of solving your clients’ problems which may arise yet comply with the statutory and regulatory requirements for 1031 exchanges and should not be viewed as a way of circumventing the law.


The material appearing in this web site is for informational purposes only and is not legal advice. Transmission of this information is not intended to create, and receipt does not constitute, an attorney-client relationship. The information provided herein is intended only as general information which may or may not reflect the most current developments. Although these materials may be prepared by professionals, they should not be used as a substitute for professional services. If legal or other professional advice is required, the services of a professional should be sought.

The opinions or viewpoints expressed herein do not necessarily reflect those of Lorman Education Services. All materials and content were prepared by persons and/or entities other than Lorman Education Services, and said other persons and/or entities are solely responsible for their content.

Any links to other web sites are not intended to be referrals or endorsements of these sites. The links provided are maintained by the respective organizations, and they are solely responsible for the content of their own sites.