Protecting Your Real Estate Investments While Deferring Taxes in a § 1031 Like-Kind Exchange
Jan. 17, 2014
When structured correctly, the exchange of real estate property using closely held business entities can result in advantageous tax treatment under the Internal Revenue Code of 1986, as amended (“IRC”), while simultaneously insulating the owner(s) from liability from potential judgment creditors. Section 1031 of the IRC, known as the “like-kind” exchange section, begins with the following statement: "[n]o gain or loss shall be recognized on the exchange of property held for 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 productive use in a trade or business or for investment." If the requirements for a like-kind exchange are met, this provision allows owners to defer the recognition of gain on appreciated real property if the real property is exchanged for replacement real property of “like kind”. Put differently, if an investor is looking to acquire real estate and also dispose of current real estate holdings, the immediate need to pay federal or state income taxes on the gain that would otherwise result from the sale may be postponed through a like-kind exchange.
§ 1031 Requirements:
The above definition contains several essential components that must be met for a transaction to qualify as a like-kind exchange. The following is a brief outline of the more material of these factors:
There must be an “exchange of property.” A simultaneous swap of real property will satisfy this requirement. The exchange may also be a deferred exchange (meaning the current disposition of property and later acquisition of the like-kind property) or a reverse exchange (meaning the current acquisition of property and later disposition of like-kind property), but additional rules and requirements will apply to these transactions, including the need to use a Qualified Intermediary for deferred exchanges and reverse exchanges, and the need to meet strict time frames for the identification and acquisition/disposition of the replacement property.
The property must be “held for productive use in a trade or business or for investment.” While no definite time period meets the “held for” criteria, the longer the property is used in a trade or business, or held for investment purposes, the greater the likelihood that the transaction will qualify for the §1031 exchange. With limited exceptions, the IRS generally takes the position that personal residences and vacation homes do not qualify for like-kind treatment.
The properties to be exchanged must be of “like-kind.” The IRS will consider the nature of the properties involved to determine if the like-kind requirement is met. Exchanges of most real property will qualify for like-kind treatment (e.g. the IRS has considered vacant land similar enough to improved land to qualify for a like-kind exchange). To the extent the investor receives cash or other property that is not like-kind, the IRS will require recognition of gain and payment of the resultant taxes.
Real Estate Transactions Using LLCs:
Many investors choose to structure their real estate transactions by setting up limited liability companies (“LLCs”) or other closely held business entities, and purchasing real property through such entities. Assuming an LLC is properly created and maintained, and its member(s) do not elect to classify it as a C-corporation for federal income tax purposes, the LLC form can insulate its member(s) from liability from potential judgment creditors while allowing pass-through taxation. Pass through taxation results in only one set of taxes for the individual member(s) (or shareholders if S-corporation classification is elected) (as opposed to C-corporations that are taxed at the entity level and again at the shareholder level when distributions are made). Additionally, holding each property in a separate LLC can reduce the exposure to risk for investors owning multiple properties in this manner, which can result in significantly more favorable loan terms. For example, a creditor who obtains a judgment against the real property owned by one LLC where the fair market value of such property is insufficient to satisfy such judgment cannot reach either the personal assets of the owner(s) of such LLC or personal assets of the other LLCs, and cannot reach the properties owned by the other LLCs in an attempt to satisfy its judgment. The insulation from risk created by the separation of ownership of the property creates an incentive for a lender to provide better loan terms, particularly when the loan is collateralized by a portfolio of properties owned in this manner.
§ 1031 Exchanges Through Single Member LLCs:
In Florida, individual investors or entities may form Single Member LLCs (“SMLLC”) to own particular real estate assets. While SMLLCs do not provide all of the protections of multi-member LLCs, a sole member of an SMLLC may receive like-kind exchange tax treatment for the exchange of either 100% of his or her membership interests in, or the real property owned by, such SMLLC for either the real property owned by a third party entity or individual, or the membership interests of a third party’s SMLLC that holds replacement property. This result is possible because the SMLLC is “disregarded” for federal income tax purposes as an entity separate from its owner; that is, federal tax law simply ignores the existence of the entity, instead treating all of the assets as owned directly by the sole member. Consequently, an investor may also receive like-kind exchange treatment if all of the § 1031 elements are met and the investor sells property owned by one of its SMLLCs and acquires replacement property using another of its SMLLCs as a part of the same transaction (or deferred or reverse like-kind exchange, as applicable). With the economy rebounding and real estate prices on the rise, like-kind exchanges should again become a prevalent tool in effective tax planning for real estate investment activity. However, tax planning for real estate transactions often involves a complicated analysis of all applicable factors and should be tailored to each individual’s situation on a case-by-case basis. Additionally, the IRC, the Treasury Regulations promulgated thereunder and other IRS publications contain certain exceptions and guidance on how to accomplish like-kind exchanges. The above is not intended to provide legal, financial or tax advice—it is only a brief outline of how like-kind exchanges under the IRC may provide owners with an opportunity to defer recognition of taxable gains for significant periods of time. Owners should always consult with a qualified attorney to assist in analyzing and structuring their proposed transactions to take full advantage of the protections and savings afforded by applicable law.