New IRS Ruling Impacts Arizona Real Estate and 1031 Exchanges

The IRS Recently Issued a ruling that is bound to impact Arizona real estate and 1031 exchanges. Revenue Procedure 2002-69 says that a husband and wife, who own all of the shares of a limited liability company (usually called an "LLC") in a community property state (ie: Arizona), will be able to disregard the separate nature of the LLC and report all of the income and expenses in their personal return.

Until now, the IRS has refused to rule on whether a husband and wife who own all of the shares of an LLC constitute a "single member" for purposes of the "disregarded entity" rules for filing a return. If an LLC has only one member, the disregarded entity rules state that the LLC does not have to file a tax return, but may instead report all of its income and expenses in the tax return of the sole member.

If a husband and wife were the sole owners of an LLC and reported the income and expenses of the LLC in their joint return, their return would look exactly the same as it would if only one of the couple owned the LLC. For several years the argument has been that a husband and wife who own all the shares of the LLC should be able to treat the LLC as a disregarded entity, especially in a community property state. Now we have that ruling, although the ruling only applies to community property states.

Let me give you an example. Fred and Sue sell their rental condo, and want to do a 1031 exchange and replace it with a larger rental property. For estate planning purposes, as well as liability protection, their attorney suggests that they take title to the new property in an LLC rather than in their own name.

While as a tax professional I agree with the business logic of the attorney's advice, it has caused serious problems with an exchange. This is because one of the requirements of a 1031 exchange is that you must take title to the new property in the same manner as you held title to the old property. So, if Fred and Sue take title to the new property in the name of their LLC, their exchange would have been disallowed.

To avoid this, Tax Professionals have used a couple of techniques to avoid the problem of couples exchanging into a property as the sole members of an LLC. Most commonly they have advised the couple that they could buy the property in their separate names and immediately transfer it to an LLC that they own.

This advice was logical but highly dangerous because the IRS tends to look through the form of the exchange to the substance – they argued that the LLC was the purchaser of the new property because it went into title so quickly.

Another technique that advisors have sometimes used is to have the couple take title to the new property in an LLC owned by the husband and wife, and then they've treated the LLC as a disregarded entity and not filed a return for the LLC. Although this made logical sense, the IRS did not agree with this approach.

But from the previous example, this new rule now states that if Fred and Sue sell the old property in their own names, they can take title the new property as an LLC, IF they are the owners of all the shares of the LLC, and IF they and the property resides in a community property state such as Arizona. It does not apply to non-community property states such as Colorado or Florida. It is not clear what impact this ruling will have in situations where the couple lives in a community property state, but the property is in a non-community state. And it is also not clear what happens if the property is in a community property state, but the couple lives in a non-community state.

There are a couple of additional angles to this ruling that I think could greatly impact the Arizona real estate market. Let's assume that Fred and his friend Jack own all of the shares of an LLC that owns a large office building. Sue, Fred's wife, could buy Jack's LLC shares, which would then make the LLC a disregarded entity. Buying Jack's LLC shares, rather than the real estate itself, will usually avoid transfer tax issues in those areas that impose them. Sue could even buy Jack's shares, instead of the actual property, to complete a 1031 exchange of her own, since the end result is that she and her husband would hold title in a disregarded entity, which will satisfy the exchange requirements.

Another angle that would work to their benefit would be if Fred and Sue bought, as their replacement property in an exchange, all of the membership interests of XYZ, LLC from Jack and Jim. Fred and Sue's purchase would satisfy the exchange requirements and they would have avoided transfer taxes.

I think that this is a great ruling for the Arizona real estate community.