Using 'Disregarded Entities' in a 1031 Exchange

One of the basic rules for holding title to property in a 1031 exchange is: "how you hold title to your old property is how you have to take title to your new property." This means that the title to the new property has to be taken by the same tax return that held title to the old property. For example, if Sue owns her old property in her personal name, she cannot have her corporation take title to her new property: the tax return that owns the old property (Sue's) is a different entity from the tax return that will take title to her new property (her corporation's). This exchange will fail.

There are four "exceptions" to the title holding rule (actually, as you will see, they are not really exceptions per se, but simply variations). These involve the use of what the IRS calls "disregarded entities." A disregarded entity is an entity that holds legal title to property but is not required to file an income tax return. The four types of disregarded entities are: Revocable Living Trusts; Illinois-type Land Trusts; Single Member Limited Liability Companies and Delaware Statutory Trusts.    

A Revocable Living Trust is an estate planning device designed to avoid probate. This type of trust holds title to property, but doesn't file a tax return. This means that if Sue owns her old property in the 'Sue Jones Revocable Living Trust,' her individual income tax return (IRS Form 1040) actually owns it, even though the Trust holds title to the old property. Therefore, Sue can take title to the new property in her own name rather than having to take title in the name of the Revocable Living Trust, because her personal tax return owned both the old and new properties.  

An Illinois-type Land Trust (also in states other than Illinois) is a title holding vehicle designed to hide the actual owners of the property from public view. If an Illinois-type Land Trust holds title to a $300,000 building as the "FGH Land Trust," and Fred, George and Howie are equal owners (called beneficiaries), then Fred, George and Howie are treated as the true owners of the property by the IRS. 'FGH Land Trust' does not file an income tax return. Instead, each of the three owners reports their one-third share of the income and expenses on their individual income tax returns. Since the individuals are treated as the owners of the property, Fred could sell his share to Ivan for $100,000, do a 1031 exchange, and then buy a replacement property in his own name. His individual income tax return owned his one-third share of the old property, and his individual income tax return will also own the replacement property. The problem with this type of land trust is that it provides no limitation to the liability of Fred, George and Howie: they can each be sued individually, or as a group, if someone slips and falls on the property.  

Limited Liability Companies (or LLCs) file partnership tax returns. Since there is no such thing as a 'one-partner-partnership,' an LLC with only one member cannot file a partnership tax return. If he tries, the IRS will send his tax return back to him, along with instructions to report all of the income and expenses on his personal 1040 tax return instead. This means that if Fred holds title to his old property in a Single Member LLC as 'Fred's Investments, LLC,' then he can sell that property, do an exchange, and take title to his new property in his name 'Fred Jones,' because his individual tax return will have owned both properties. The benefit of an LLC is that it protects you from liability. But if Fred, George and Howie want to buy a property together, have the protection of an LLC, and be able to do separate exchanges, they will each need to form a Single Member LLC to hold their interest. This becomes cumbersome and a lender may not want more than one entity in title to the property when it makes the loan.    

The final type of disregarded entity is called a Delaware Statutory Trust (or "DST"). DSTs combine the best of Illinois-type Land Trusts and Single Member LLCs. You take title to the property in the name of the DST while each person (called a 'beneficiary') is treated as the owner of their share of the property (as in the Land Trust). And like an LLC, the DST protects the individual owners from liability without the hassle of setting up and taking title to the property using multiple LLCs. This could be the solution if the lender wants a single borrower on the loan for the property, but Fred, George and Howie want the ability to do separate exchanges when they sell. DSTs are relatively new and have limitations, but can be the real solution to sticky ownership issues.    

The last thing I want to point out is that it is possible, and common, to chain together a series of disregarded entities. A building that is owned by a single member LLC, with the Sue Jones Revocable Living Trust as the sole member, is for IRS and 1031 exchange purposes, owned by Sue Jones herself. Revocable Living Trusts, Illinois-type Land Trusts, Single Member Limited Liability Companies and Delaware Statutory Trusts are all very useful when customized to your specific situation. Just be very careful when hiring a 1031 qualified intermediary. Do your due-diligence to be certain the QI you hire knows how to properly handle disregarded entities.