Like-kind Exchanges with Disregarded Entities

Often a taxpayer considers the potential tax benefits of a like-kind exchange when selling and acquiring real estate. Although the like-kind exchange rules of Sec. 1031 are complex, the benefit of tax deferral can be enormous. Basically, Sec. 1031 provides that gain is deferred when a taxpayer exchanges property held for use in a trade or business or for investment purposes for like-kind property. There are four required elements in a Sec. 1031 exchange: (1) It must involve a transfer of real or personal property; (2) the property must be held for a qualified purpose (i.e., as investment or in a trade or business); (3) the property relinquished must be like-kind with the replacement property; and (4) an exchange is required.

The determination of whether properties are like-kind is based on their nature or character, not their grade or quality. Because real estate is generally real estate for like-kind purposes, Sec. 1031 is a useful tool when contemplating a sale of real estate. Sec. 1031 specifically excludes the applicability of the like-kind provisions to exchanges of stock in trade or other property held primarily for sale; stocks, bonds or notes; other securities or evidences of indebtedness or interest; interests in a partnership; certificates of trust or beneficial interests; or choses in action. Regs. Sec. 1.1031(a)-1 states that Sec. 1031(a)(1) " does not apply to any exchange of interests in a partnership regardless of whether the interests exchanged are general or limited partnership interests or are interests in the same or different partnerships."

The IRS has ruled that one of the integral requirements of a like-kind exchange is the exchange requirement. For example, in Letter Ruling (TAM) 9818003, the Service ruled that a partnership did not qualify for like-kind exchange treatment when it relinquished property but had deeded replacement properties directly to partners in liquidation of their partnership interests. The partnership owned the relinquished property and sold it to a third party. The transaction provided that each partner could designate one or more properties that the partnership would acquire using the respective partner's share of the net proceeds from the sale. The exchange trust disbursed funds to acquire the replacement properties for the partners, which were deeded directly to the individual partners in liquidation of their partnership interests. The IRS ruled that, to meet the exchange requirement of Sec. 1031, there must be a reciprocal transfer of property. The taxpayer could not satisfy this test, because it transferred the relinquished property but received no replacement property.

With the advent of disregarded entities (single-member limited liability companies (SMLLCs)), practitioners were uncertain how the Service would view a taxpayer's sale of relinquished property and the acquisition of replacement property by a disregarded entity. It was not clear whether a taxpayer in this situation met the exchange requirement of Sec. 1031. However, several recent IRS rulings should give practitioners comfort when dealing with a like-kind exchange in which the property is acquired by the disregarded entity or the taxpayer acquires an interest in a disregarded entity as replacement property.

One of the earliest rulings on this issue was Letter Ruling 9807013. A limited partnership that created single-asset entities to receive several parcels of real estate as replacement property in a like-kind exchange was treated as having directly received those properties for Sec. 1031 purposes. The taxpayer's relinquished property was a single parcel of unimproved land, which was exchanged for several different replacement properties. The financing arrangement relating to the replacement properties required that each property be held in a single-asset entity. The ruling concluded that, as a result of Regs. Sec. 301.7701-2(c)(2), a business entity that has a single owner and is not a corporation is disregarded as an entity separate from its owner for Federal tax purposes, unless that entity elects to treat itself as an association taxed as a corporation. Therefore, the taxpayer's receipt of property by the replacement entities was treated as the receipt of real property directly by the taxpayer for purposes of qualifying as a like-kind exchange.

A similar result was reached in Letter Ruling 9911033. The taxpayer was a grantor trust that held a parcel of real estate it wanted to sell. The taxpayer had replacement property that it wanted to acquire with the exchange proceeds and some new debt. The lender insisted that legal title to the replacement property be held by a bankruptcy-remote entity. To satisfy this requirement, the trust formed a SMLLC to which the replacement property was transferred. As long as the SMLLC did not file an election to be treated as a corporation for Federal tax purposes under Regs. Sec. 301.7701-3(c), it would be disregarded as a entity separate from the trust, and the acquisition of the replacement property by the SMLLC would be treated as a direct acquisition by the trust for Sec. 1031(a)(3) purposes.

In Letter Ruling 200118023, the Service further expanded the available use of SMLLCs in conjunction with Sec. 1031 transactions. The qualified intermediary in the transaction held replacement property in a SMLLC. Instead of transferring the real property to the taxpayer, the intermediary transferred the SMLLC interest. The receipt of the SMLLC interest by the taxpayer was treated as a receipt of qualifying replacement property. The IRS ruled that, because the SMLLC was a disregarded entity, the receipt of the SMLLC interest was treated as receipt by the taxpayer of the real property owned by the SMLLC. This result was very favorable for the taxpayer, as the direct transfer of the real estate would be subject to a real estate transfer fee while the transfer of the LLC interest was not.

Since the advent of SMLLCs, they have become a widely used entity in many different types of transactions. Additionally, with the issuance of Rev. Proc. 2000-37 (which provides a safe harbor for reverse-like-kind exchanges and for liability reasons), many qualified intermediaries are holding replacement property in SMLLCs. Based on recent IRS rulings related to SMLLCs and like-kind exchanges, taxpayers and practitioners can be comfortable that they can meet the strict requirements of Sec. 1031 with the use of these entities in exchange transactions. In addition, in transactions similar to the one in Letter Ruling 200118023, taxpayers may even be able to save real estate transfer fees, by acquiring the SMLLC interest rather than a direct interest in real property.

From Tracy J. Monroe, CPA, MT, Cohen & Company, LTD, Cleveland, OH