Disregarded Entity and 1031 Exchanges

The answer to that question is described in the SAME TAXPAYER RULE, which interestingly enough, is not specifically delineated in the Internal Revenue Code, but is a basic requirement for a Section 1031 Exchange.

What does this mean? The taxpayer acquiring a Replacement Property must be the same party or legal entity as the taxpayer who sold the Relinquished Property.

In many cases, rules are just made to be broken OR said another way: sometimes there are exceptions to the rule.

There are three (3) exceptions to the SAME TAXPAYER RULE pertaining to the title transfer and receipt of Section 1031 Replacement Property. They are (1) Delaware Statutory Trusts; (2) Revocable Living Trusts or Grantor Trusts; and (3) Single-Member LLCs. All of these entities are considered by the IRS to be DISREGARDED ENTITIES.

What is a DISREGARDED ENTITY?

A disregarded entity refers to a business entity with one owner that is not recognized for tax purposes as an entity separate from its owner. The IRS classifies a single-member LLC by default as a disregarded entity and treats the business as a sole proprietorship for income tax purposes.

In the majority of cases, an individual owner, owning a piece of real estate in their own name, will be liable for any damages caused by or on its property. That owner will also be responsible for any taxes owed on that real property. If someone should obtain a judgment against the property or the owner, that judgment would attach to the property and against any other assets the owner may own. But if the property is owned as a Disregarded Entity, any judgments or liens would attach only against the property, not against the owner individually.

The important point to note is that if the title to the real estate is in a Disregarded Entity, the owner of the property might lose the property or have a judgment against the property, BUT those judgments or liens would not attach against any other of the owner’s assets. That is a major plus benefit for the owner. Additionally, any profits or losses related to the Disregarded Entity would pass right through to the owner and would be reflected on the owner’s personal tax return.

EXAMPLE: Tom Ato owns two different properties, property #A and property #B. He holds each of these properties in his personal name, Tom Ato. If the mailman should fall on a banana peel on Tom’s property # A, Tom could be sued and a judgment would attach against both Property #A and Property #B, as well as against Tom. If Tom had put both of these properties in their own separate Disregarded Entities, then the judgment would only attach against Property #A. The other property (Property # B ) would be free and clear from that judgment.

So, let’s briefly discuss the three (3) exceptions that qualify for Disregarded Entity status.

Exception #1 DELAWARE STATUTORY TRUST (DST)

In 2004, IRS issued Revenue Ruling 2004-86 which if followed properly, allows certain Delaware Statutory Trusts to be treated for IRS purposes as a Disregarded Entity. The beneficial owners of the DST are allowed the same liability protection as shareholders of a Delaware corporation. Today, there are many Sponsors (a/k/a Promotors) of DST’s providing undivided percentage real property interests in real estate, as possible Replacement Property for the Exchangor.

Exception #2 REVOCABLE LIVING TRUST OR GRANTOR TRUST

Many estate tax planning attorneys suggest that the taxpayer hold their replacement property in a revocable living trust or grantor trust. Section 1031 allows for the Section 1031 tax deferment using either of these types of trusts.

Exception #3 SINGLE-MEMBER LLC

Numerous real property owners, in a Section 1031 exchange transaction, desire to hold title to their new Replacement Property in the form of a Limited Liability Company (LLC). The good news is that the IRS has ruled that a single-member LLC can qualify as a Disregarded Entity. For Example, Rose Mary has title to her investment real estate in her own name. She hires Liberty 1031, LLC to act as her Qualified Intermediary on the transfer of her Relinquished Property. After the Relinquished Property transaction has occurred, she closes on her Replacement Property in the name of a single-member LLC, of which she is the only owner. She will receive the liability protection of an LLC and any income, losses, depreciation, etc. will be reflected on her personal tax return. In other words, as my former Tax Law Professor used to say: “ she gets the best of both worlds.”

Please remember to inform the Qualified Intermediary if the name on the Replacement Property is going to be different than the name on the Relinquished Property. In some cases, the different names or legal entities, might not be allowed under Section 1031 rules

For more information on Section 1031 issues go to our website: www.liberty1031.com  and visit our 1031 FAQ, Section 1031 Basics, and Section 1031 Case Studies.   Or call us today at 866.903.1031. We look forward to working with you on future Section 1031 exchanges– Steve