A 1031 Exchange is a powerful tax-saving strategy that allows investment property owners to defer paying capital gains tax when selling property. To take advantage of this strategy, property owners must reinvest the sales proceeds into a “like-kind” investment property of equal or greater value and meet the conditions outlined in the IRS tax code.
While this tax-saving strategy can be highly beneficial, co-ownership of an investment property can create a stumbling point for real estate investors. Co-ownership can introduce complexities and potential conflicts that must be carefully navigated to complete the exchange successfully. In this article, we will explore different types of co-owned property and what to consider with each when performing a 1031 Exchange.
A partnership is a property ownership structure in which two or more individuals or entities co-own the property. Partnerships can face unique challenges when it comes to 1031 Exchanges, particularly if one or more partners intend to cash out their interest during the transaction. In such cases, one solution is for the partner(s) who wish to be cashed out to receive a distribution of their partnership interest in advance of the sale in the form of an undivided interest in the relinquished property. The distribution creates a Tenant-In-Common (TIC) ownership structure with two interests: the original partnership (minus the partner(s) intending to pay tax on their sales proceeds) and the newly formed entity containing the partner(s) intending to receive cash proceeds from the upcoming sale of the property. By using this approach, the tax ID number of the original partnership is preserved, and the process circumvents the “seasoning” period some feel is necessary if the entire partnership is converted to a Tenant-In-Common.
An alternative solution is for the partnership to exchange into multiple properties selected by individual partners and amend the partnership by-laws so that the majority of the rights of each respective property are initially allocated to the individual partners who selected the respective properties. The other partners take minority positions in all properties except those in which they are allocated the majority position. Following the exchange, the partnership is dissolved and each partner receives the property of which they are the “majority owner” of as their liquidating distribution. This approach gives each partner control over their investment and the ability to invest in property that aligns with their individual goals and objectives. However, the strategy does rely on each partner’s successful acquisition of their selected replacement property. Otherwise, a tax liability is created and shared among the partnership. Thus this approach is commonly used with replacement properties such as Delaware Statutory Trusts (DSTs), where there is little risk of closing on replacement property.
Other options for partnerships include direct partner buy-outs and partnership divisions consistent with IRC §708(b)(2) are also possible before, during, or after an exchange.
LLCs are a popular way to hold investment property due to the liability protection they provide. For 1031 exchange purposes, the structure of the LLC can impact how the exchange is treated for tax purposes. A single-member LLC used for liability protection will be treated as a sole proprietorship for exchange purposes and rarely will have its own tax identification number (TIN) – commonly referred to as a “disregarded entity.” In contrast, a multi-member LLC that has not elected to be taxed as a corporation will be treated as a partnership for tax purposes and for exchanges as well. The LLC will have a unique tax identification number for the entity and be considered a “regarded entity” for tax purposes. As a result, many of the entity restructuring techniques discussed earlier, which relate to partnerships, can also be used for multi-member LLCs. In fact, these techniques may be even easier to implement within a multi-member LLC structure.
Trusts are a common vehicle for holding investment property, but their structure can have implications for 1031 Exchanges. A trust can be either revocable or irrevocable. A revocable trust, in which the grantor of the trust’s assets maintains 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.
In contrast, if a 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 – the 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 simple interest in real property.
The Bottom Line
Navigating a 1031 Exchange with co-owned investment property can be complicated, but there are many approaches that can be used to address the goals and objectives of each co-owner. While there are numerous co-ownership structures that can introduce complexities, rarely is an investor’s situation insurmountable.
At Real Estate Transition Solutions, we understand that every property owner’s situation is unique, and we are dedicated to finding tailored solutions to meet your specific needs. Contact Real Estate Transition Solutions (RETS) to speak with a licensed 1031 Exchange Advisor. We offer complimentary consultations that can be done over the phone, via video conference, or in person at one of our offices. To schedule your consultation, call 888-286-5395 or visit us at re-transition.com/aoa.
As Chief Exchange Strategist, Austin leads the firm’s team of licensed 1031 Exchange advisors & analysts and provides consultation on tax liability, deferral strategies, legal entity structuring, co-ownership arrangements, 1031 replacement property options, and Delaware Statutory Trust investments.
Real Estate Transition Solutions (RETS) is a consulting firm specializing in tax-deferred 1031 Exchange strategies and Delaware Statutory Trust investment property. For over 26 years, we have helped investment property owners perform successful 1031 Exchanges by developing and implementing well-planned, tax-efficient transition plans carefully designed to meet their objectives. To learn more about 1031 Exchanges and Real Estate Transition Solutions, visit re-transition.com/aoa or call us at 888-286-5395.
IMPORTANT INFORMATION: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 sponsor’s Private Placement Memorandum (PPM), which is solely available to accredited investors and accredited entities. Examples are for illustrative purposes and are not representative of future results. There are risks associated with investing in real estate properties, including, but not limited to, loss of entire investment principal, declining market values, tenant vacancies, and illiquidity. Because investor 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 situation. DST 1031 properties are only available to accredited investors (generally described as having a net worth of over $1 million 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. Securities are offered through Aurora Securities, Inc. (ASI), member FINRA/SIPC. Advisory services are 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.