Structuring Single Purpose Entities in 1031 Exchanges

What happens to your 1031 exchange if the lender requires that you take title to your New Property in its own separate, single purpose entity -- like an LLC? Will it toast your exchange? Is there a way to salvage the exchange? What are your options?

This is a common problem, especially with commercial properties. From the lenders standpoint, a "single purpose," or "bankruptcy remote" entity makes sense. What the lender is seeking to prevent is another of your properties that might be having problems from dragging down this one good property and putting their loan in jeopardy.

But what does this do to your exchange? Section 1031 requires that the same tax return that held title to your Old Property take title to your New Property. Let's say that your Old Property was owned by Black Acres Partnership. The lender won't make the loan to Black Acres because of the other properties it owns, and insists on a separate entity owning it. But won't this violate the exchange rules? Yes, but there is a way to make this work -- it's called a "disregarded entity."

Disregarded entities are entities that the IRS has determined need not file a tax return -- the income and expenses arising from that property are reported in the tax return of the entity, or person, who owns it. Basically, there are three types of disregarded entities -- we'll focus on two of the most common.

The one many of you are most familiar with is the revocable living trust.

Those of you who use living trusts as an estate planning device know that you don't file a return for the property owned by the trust, and that the income and expenses (and dividends and interest) arising from the trust is reported in your own IRS Form 1040. The Living Trust is therefore disregarded for income tax reporting purposes.

The second type of disregarded entity, and the most appropriate to solve your problem, would be a "single member, Limited Liability Company." Limited Liability Companies or "LLCs" file a partnership tax return with the IRS -- and because there can be no such animal as a "single partner partnership" -- the IRS has declared that single member LLCs are disregarded entities! Any income or expense from the assets owned by the LLC must be reported in the tax return of the LLCs sole member.

So let's go back to your situation. Black Acres Partnership sold the Old Property and the lender is now telling you that you have to have a single asset, bankruptcy remote entity owning the New Property. The solution to the problem is to set up a separate, single member limited liability company to take title to the New Property. Let's call this LLC White Acre.

So now, White Acre, LLC, whose single member is Black Acres Partnership, takes title to the New Property.

Because Black Acres is the sole member, the IRS considers the New Property to be actually owned by Black Acres even though White Acre is technically the legal owner.

The result for 1031 exchange purposes is that Black Acres sold the Old Property, and Black Acres bought the New Property, thereby satisfying the 1031 exchange requirements.

...Forming a "disregarded entity" can solve the title problem and make your exchange work...!

Another scenario is also true for exchangers: What if you owned and sold your Old Property in say, just your name, and wanted to buy the New Property in an LLC -- for protection from litigation or operational purposes? This concept of a disregarded entity by the IRS, selling in just your name and buying as an LLC -- if the single-member of that LLC is you -- allows you to again accomplish your exchange. In some states, both husbands and wives constitute a 'single-member' and therefore a husband & wife LLC is also a disregarded entity.

Make sure you choose an intermediary that has both the legal skill sets and the accounting experience to help you through this critical step.