Property Ownership Structure and 1031 Exchanges
Co-ownership structure issues are one of the most common stumbling points for 1031 exchanges, however this need not be the case. With proper understanding and planning, most co-ownership structures can be worked through to satisfy the co-owner’s respective investment objectives.
One common situation we advise clients in is the exchange of property owned by either a partnership or LLC in which one or more of the partners/members intends to cash out their interest at the time of the transaction.
One possible method is for the partner(s) who wish to be cashed out of the partnership to receive a distribution of their partnership interest in the form of an undivided interest in the relinquished property in advance of the sale of the property, essentially creating a Tenant-In-Common ownership structure with two interests – the original partnership (less the partner(s) intending to pay tax on their sales proceeds) and the newly created entity containing the partner(s) intending to receive cash proceeds from the upcoming sale of the property. This approach preserves the tax ID number of the original partnership and thus does not have a one-year “seasoning” period that would be required if the entire original partnership were converted to a Tenant-In-Common.
Due to the fact that an exchange can identify and close on multiple replacement properties, another approach arises. A partnership can exchange into multiple properties, then amend the partnership by-laws so that the majority of the rights of each respective property are initially allocated to each individual partner with the other partners taking minority positions in all properties except that which they are allocated the majority of. Once the properties have been held in this form for one year or more, the partnership can be dissolved, and each partner can receive the property they are the majority owner of as their liquidating distribution.
Other approaches such as direct partner buy-outs and partnership divisions consistent with IRC §708(b)(2) are also possible before, during, or after an exchange.
Sole-owner LLCs in which the property is held by an LLC in order to gain liability protection are considered to be sole proprietorships for exchange purposes. A multi-member LLC that has not elected to be taxed as a corporation is considered to be a partnership for tax purposes and will be treated as such for exchanges as well, thus many of the
entity restructuring techniques described earlier, as they relate to partnerships, are still possible and perhaps even easier within the context of a multi-member LLC
Generally, trusts fall in two overall categories, revocable and irrevocable. Trusts in which the grantor of the trust’s assets maintain their power of revocability through IRC §676 are considered to be “disregarded entities” for tax purposes, thus the grantor is considered to be the taxpayer exchanging the property. If the trust is irrevocable the trust itself is considered to be the taxpayer and any replacement property must in its entirety be owned by the same entity. Note, that trustee(s) are not considered to be the taxpayer(s) performing the exchange, regardless of whether the grantor is deceased or not. The exception to this rule presents a unique ownership structure referred to as DSTs.
Delaware Statutory Trusts (“DSTs”) are used to facilitate ownership of property by multiple owners. In a DST, a trustee holds legal title to a property, and investors can purchase “beneficial interests” in the trust. In Revenue Ruling 2004-86, the IRS determined that the 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.
While there are numerous other co-ownership structures, many of which are nuanced, rarely is an investor’s particular situation insurmountable. Do not hesitate to contact us if you have any questions regarding the specifics of your ownership structure when evaluating your options.
Austin Bowlin, CPA and Partner at Real Estate Transition Solutions, provides exit strategy analysis, execution, income and equity replacement options for investment property owners. If you have questions relating to your investment property and would like to learn more about tax-deferred 1031 Exchanges, please email him at firstname.lastname@example.org or call (206) 686-2211.
The information herein has been prepared for educational purposes only and does not constitute an offer to purchase or sell securitized real estate investments. Such offers are only made through the sponsors Private Placement Memorandum (PPM) which is solely available to accredited investors and accredited entities. DST 1031 properties are only available to accredited investors (generally described as having a net worth of over $1 million dollars exclusive of primary residence) and accredited entities only. If you are unsure if you are an accredited investor and/or an accredited entity please verify with your CPA and Attorney. There are risks associated with investing in real estate and Delaware Statutory Trust (DST) properties including, but not limited to, loss of entire investment principal, declining market values, tenant vacancies and illiquidity. Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated. Diversification does not guarantee profits or guarantee protection against losses. Because investors situations and objectives vary this information is not intended to indicate suitability for any particular investor. This material is not to be interpreted as tax or legal advice. Please speak with your own tax and legal advisors for advice/guidance regarding your particular situation. Securities offered through Aurora Securities, Inc. (ASI), Member: FINRA/SIPC. Advisory services offered through Secure Asset Management, LLC (SAM), a Registered Investment Advisor. ASI and SAM are affiliated companies. Real Estate Transition Solutions (RETS) is independent of ASI and SAM.