Typically, commercial real estate or unimproved property is held in a multi-member limited liability company (“LLC”). Under this structure, the promoter of the investment is typically entitled to share with the investors the distributions made by the LLC once the investors have received a return of their capital and a specified internal rate of return. The popularity of this structure arises, in part, from various tax benefits such as the flow-through of depreciation deductions to the investors and long-term capital gain treatment to the promoter on distributions made by the LLC. However, one apparent short-coming of the structure from a tax perspective is the complexity that occurs upon a sale of the property if some investors desire tax-deferred like-kind exchange treatment and others desire to pay the tax arising from the sale and to cash out their investment.
One structure that we have seen commonly proposed in connection with a sale of a property where some, but not all, of the investors want like-kind exchange treatment is the so-called “drop and swap” structure. Under this structure the following occurs:
The “drop and swap” structure, in concept, appears to be a relatively simple real estate transaction. However, tax guidance issued by the IRS and various court cases indicate that a failure to follow certain formalities could prevent the parties from obtaining the desired tax treatment. Thus, prior to adopting a "drop and swap" structure, full consideration should be given to the potential tax risks that can arise in the structure.
Under Section 1031, the gain arising from the sale of real estate can be deferred if the disposition of the real estate is structured as a like-kind exchange which satisfies the conditions of Section 1031. Among these conditions is that the owner of the real estate acquire property that is of a “like-kind” to the relinquished property. Under this “like-kind” requirement, the disposition or acquisition of a membership interest in a LLC that is classified as a partnership for U.S. federal income tax purposes can never qualify as like-kind property. This is true even if the taxpayer uses the proceeds distributed to him by the multi-member LLC from the sale of the relinquished property to acquire an interest in a multi-member LLC that also owns real property.
For purposes of this rule, only multi-member LLCs are classified as partnerships for U.S. federal income tax purposes. In contrast, single member LLCs are typically classified as disregarded entities and not as partnerships for U.S. federal income tax purposes. Thus, this like-kind issue with respect to property held by LLCs will be of a concern only where the property-owning LLC has more than one member.
Example 1: Mr. White owns a 33 percent membership interests in WWW, LLC which owns a retail center in suburban Chicago. Assume that the retail center is sold while it is owned by WWW, LLC and that Mr. White uses his share of the sale proceeds to acquire all of the membership interest in another LLC that owns a different retail center. Because WWW, LLC and not Mr. White owned the property at the time of its sale, Mr. White will not be able to defer the gain arising from the sale by WWW, LLC under the like-kind exchange rules of Section 1031 even if all of the conditions set forth in Section 1031 can be otherwise satisfied.
Example 2: Same facts as Example 1 above except assume that prior to the sale of the retail center, WWW, LLC distributes the ownership interests in the retail center to Mr. White, Ms. Williams and Ms. Waters as co-owners and, after the distribution, Mr. White, Ms. Williams and Ms. Waters as co-owners sell the retail center. Assume that Mr. White uses his share of the proceeds to acquire a 100 percent membership interest in another LLC that owns a different retail center. Even though Mr. Williams did not own the relinquished retail center at the time of its sale through a multi-member LLC, there are some circumstances in which the Internal Revenue Service (the “IRS”) could re-cast the co-ownership structure as a partnership for U.S. federal income tax purposes. If the IRS determines that the co-ownership structure is to be classified as a partnership for U.S. federal income tax purposes, Mr. White will not be able to defer the gain arising from the sale of the relinquished retail center under the like-kind exchange rules of Section 1031 even if all of the conditions set forth in Section 1031 can be otherwise satisfied.
As described above, the structure in which a multi-member limited liability conveys its real property to its members to hold as co-owners prior to the sale of the property is typically referred to as a “drop and swap” structure. However, members of an LLC that are contemplating the use of a “drop and swap” structure must consider that if the co-ownership gets re-cast by the IRS as a partnership for federal income tax purposes, tax-deferred like-kind exchange treatment will not be allowed. As a result, members of LLCs contemplating the “drop and swap” structure must confirm that the co-ownership is properly structured for U.S. federal income tax purposes.
Reported tax cases indicate that in the context of examining whether a transaction satisfied this “like-kind” requirement, the IRS has succeeded in re-casting co-owner structures as partnerships for income tax treatment. See Luna v. Comm’r, 42 T.C. 1067 (1962); Comm’r v. Culbertson, 337 U.S. 733 (1949); Bergford. v. Comm’r, 12 F3d 166 (9th Cir. 1993). Based upon the holdings of these reported cases, a multi-factor test is generally used by the IRS to determine whether a co-ownership structure must be re-cast as a partnership for purposes of applying the like-kind requirement. These factors are often referred to by tax advisors as the “Luna Factors.”
In 2002, the IRS issued Revenue Procedure 2002-22 which set forth guidelines under which the IRS will issue a private letter ruling on whether a co-ownership TIC structure would be recast as a partnership for purposes of applying the like-kind requirement. The Revenue Procedure applies some, but not all, of the Luna Factors. In fact, Revenue Procedure 2002-22 includes factors in addition to the Luna Factors in these advance ruling guidelines.
It is important to note that Revenue Procedure 2002-22 clearly states that the factors set forth in the Revenue Procedure are not intended to be a substantive statement of tax law. In fact, in many of the private letter rulings issued by the IRS after the issuance of Revenue Procedure 2002-22, the IRS found like-kind exchange treatment even though some of the factors set forth in the Revenue Procedure were not satisfied. Thus, an examination of whether a co-ownership structure can be re-cast by the IRS as a partnership for purposes of the like-kind exchange should be based on the analysis applied by the courts in Luna, Culbertson and the other cases in which this issue has been examined and use Revenue Procedure 2002-22 only as a guidepost.
In light of existing guidance on the relevant tax issues, parties considering a "drop and swap" structure should examine the following:
Prior to the “drop and swap,” the governance rights of the members would be set forth in the operating agreement of the LLC that owned the property. After the conveyance of the property by the LLC to the co-owners, the parties would enter into a written tenancy in common agreement which sets forth the governance rights of the co-owners. One of the differences between the operating agreement and the tenancy in common agreement is that the same voting rights set forth in the operating agreement might not be permitted in a tax-compliant co-ownership structure. Specifically, both Revenue Procedure 2002-22 and the reported tax cases indicate that any decision to sell, refinance, or to enter into any loan will require the consent of all of the co-owners (i.e., unanimous consent). In addition, unanimous consent is required for leasing activities.
There are other requirements that will also have to be addressed in the co-owners' agreement such as the mechanics for hiring and firing the asset/property manager, exercising a right to partition, and how distributions are to be made. For example, distributions under a tax-compliant co-ownership structure, net of fees (at market rates), must be made solely in accordance with each co-owners' ownership interest. Thus, the inclusions of non-market fees or a non-pro rata distribution (e.g., to a promoter) will increase the tax risk that the co-ownership structure could be recast as a partnership.
Under both Revenue Procedure 2002-22 and the reported cases, there will be significant tax risk if one of the co-owners is given responsibility for collecting rents and operating the property. In other contexts, the activities of a multi-member LLC can be imputed to its members. Thus, if one of the members will act as the asset and property manager, the use of a corporation might reduce the risk that the co-ownership structure could be recast as a partnership for purposes of the like-kind requirement. In addition, under Revenue Procedure 2002-22, the term of any asset and property management agreement cannot exceed one year (but it can be subject to automatic annual renewal under certain circumstances). Thus, the existence of an asset and property management agreement between the co-owners and another party can reduce the risk that the co-ownership structure could be recast as a partnership for purposes of the like-kind requirement.
Even if the co-owners enter into a co-ownership agreement and an asset and property management agreement that addresses the requirements of a tax-compliant co-ownership structure, the co-owners will continue to face tax risk if the LLC continued to collect the rents and to oversee the operation of the property. For example, if, after the conveyance of the property by the LLC to the co-owners, the tenants continue to pay rent to a bank account of the LLC or if the leases are not assigned by the LLC to the co-owners, the co-owners will face increased risk that the co-ownership structure could be recast as a partnership for purposes of the like-kind requirement.
If the property owned by the multi-member LLC is subject to a mortgage and the loan documents require the consent of the lender for a transfer, a failure to record the conveyance or obtain lender consent could increase the risk that the co-ownership structure could be recast as a partnership for purposes of the like-kind requirement.
The date on which the conveyance of the property by the LLC to the co-owners could be viewed as a relevant factor in determining whether the “drop and swap” structure will be respect by the IRS. In addition to the like-kind requirement, the requirements for tax-deferred like-kind exchange treatment set forth in Section 1031 require that the exchanging taxpayer hold the relinquished property “for investment.” If the conveyance of the property by the LLC to the co-owners is not recorded until the moment before the sale of the property to a third party, the co-owners will face substantial risk that the IRS could conclude that the co-owners acquired their co-ownership interest in the property for purposes of immediately selling it rather than for investment.
While the “drop and swap” structure appears to be very straightforward, ignoring the mechanics required for a tax-compliant co-ownership structure could significantly increase the risk that the IRS could find that the co-owner failed to satisfy the “like-kind” requirement set forth in Section 1031. If the IRS concluded that the co-owner could not properly claim like-kind exchange treatment, the co-owner will be required to pay taxes on the gain arising from the sale of the relinquished property notwithstanding that the co-owner used the sale proceeds to acquire replacement property.
Having the “drop and swap” structure reviewed by a tax attorney who is familiar with the TIC structure and Revenue Procedure 2002-22 will provide the co-owner with an opportunity to minimize this tax risk and in some cases, the issuance of a tax opinion could help the co-owner avoid tax penalties should the IRS assert that notwithstanding the adoption of the “drop and swap” structure, the co-owner failed to satisfy the like-kind requirement.
One of the most common questions asked of a qualified intermediary involves the situation in which one or more members or partners in a limited liability company (LLC) or partnership wish to effect a 1031 exchange and others simply wish to cash out. There are several practical difficulties in this regard starting with Section 1031 itself. The section generally provides
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged for property of like kind which is held for productive use in trade or business or for investment”.
However the section also provides for several exclusions to the ability to trade any qualified use asset and one of those exclusions states “This subsection shall not apply to any exchange of interests in a partnership." As a result, the challenge here is to allow members to go their separate ways while not deeming them attempting to trade in their capacities as members.
While there are multiple ways to structure transactions allowing various members to effectively trade their interest, by far the most common technique is for the outgoing member to have the LLC redeem the member’s interest and to convey by deed the applicable percentage interest in the property equivalent to the member’s former share. The transfer to the member and the subsequent trade by that person is generally referred to as a “drop and swap.”
A drop and swap can take place in several different ways. As mentioned above, when the majority of members wish to cash out, the taxpayer can transfer his membership interest back to the LLC in consideration of his receipt of a deed for a percentage fee interest in the property equivalent to his former membership interest. The taxpayer would then own a tenant in common (TIC) interest in the relinquished property together with the LLC. At closing each would provide their deed to the buyer and the former member can direct his share of the net proceeds to a qualified intermediary.
At times, the majority of members will wish to complete an exchange and one or more minority members will wish to simply cash out. The drop and swap can be used in this instance also by dropping applicable percentages of the property to the exiting members while the limited liability company completes an exchange at the LLC level and the former members cash out and pay the taxes due.
As indicated above, in order for property to be exchanged, it must have been held by the taxpayer for use in a business or for investment. So, if on the eve of the closing on the sale of the relinquished property a fee interest is conveyed to the exiting member, that member would be hard pressed to claim that she personally had held the property for any real period of time. However, when outgoing members wish to cash out, the “held for” requirement is less of an issue since the exchange is done at the LLC level and the LLC has clearly held the property for a qualified use for a significant length of time. It does not matter that the outgoing members will not have satisfied the holding period requirement since they are not seeking exchange status.
For quite some time there have been recommendations from different groups to the IRS to allow outgoing members to be able to tack on their holding period as members to their individually-held ownership interest prior to an exchange. The Joint Committee of Taxation, which every several years comes up with suggested tax-related recommendations, has stated:
“For purposes of determining whether property satisfies the holding requirement under Section 1031 like kind exchange rules, a taxpayer’s holding period and use of property should include the holding period of and use of the property by the transferor, in the case of property….distributed by a partnership to a partner…”
To date the IRS has not adopted this position. If anything, over time the drop and swap appears to be increasingly disfavored by the Service.
In 2008, as part of the IRS’ attempt to limit drop and swap transactions, Schedule B 14 was added to Form 1065. Schedule B 14 asks “At any time during the tax year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property." Prior to the inclusion of this check-the-box requirement, drop and swaps were frequently done on a “don’t ask, don’t tell” basis.
As a result of this reporting requirement, it is far better, when planning on a member exchange, to distribute out to the member(s) in a tax year prior to the year in which the sale of the property takes place. This enhances the holding period requirement and separates the drop to a prior tax year from the year in which the former member is completing an exchange. Most Section 1031 experts also strongly suggest making any of these changes prior to entering into a contract for sale.
When a deed of conveyance to a fractional interest in the real estate is given to the outgoing member, that deed is subject to whatever debt is on the property, however the debt is an obligation of the LLC and not that of the member. As a result, the conveyance does not, by itself, act to transfer a pro-rata amount of debt to that member. In order to avoid all the debt remaining against the LLC, the Operating Agreement or the Partnership Agreement needs to be amended to allow for a special debt allocation to flow through to the member as part of his receiving a deed to the fractional interest.
Almost all loans secured by property contain “due on transfer” clauses. So conveying an interest in the property to one or more members may constitute a technical violation under the loan documents. This is often overlooked since the loan payments are kept current and the property would likely be sold before a lender took notice of any transfer.
There is a long history of case law in which the IRS has successfully argued that if a TIC holding has the attributes of a partnership, the co-ownership relationship will be deemed a partnership. This would negate a drop and swap. Although there are many factors that go into determining whether a co-ownership constitutes a de facto partnership, the single largest factor is the degree in which the property is managed by the TICs. The least amount of management by the co-owners is helpful to avoid partnership characterization. Often in an attempt to deal with this consideration, the co-owners will appoint a single co-owner as management agent for the group or will have an outside management company manage the property.
For other various reasons, co-ownership groups will sometimes enter into a tenant in common agreement setting forth their respective rights and relationship. The terms of such an agreement comes from IRS guidance in the form of Rev. Proc. 2002-22. These agreements are often used by lawyers advising clients in order to rebut the argument of a deemed partnership. It is generally understood in the legal community that it is almost impossible for a co-ownership structure to adhere to each and every requirement set forth in the Rev. Proc., but many people try to pattern a tenant in common arrangement to include as many of the provisions as possible. Caution should be taken to avoid the situation where a TIC agreement is entered into but its terms are ignored in whole or in part by the co-owners.
The possibility of structuring of a 1031 exchange by a subsection of the partners in a partnership or members in an LLC, is one of the most common questions asked by taxpayers to their exchange facilitator or their advisers. While at one time this was done regularly and with apparent impunity, over time the IRS has taken steps to limit this deferral opportunity when the taxpayer has failed to hold the property for an amount of time. The technique of “dropping” an interest to a partner in the form of a tenant in common ownership of title to the property and then “swapping” that interest is very popular. The same can be true when a member wishes to cash out where the LLC seeks to do an exchange. There are some planning steps that can be taken in order to provide the exchange transaction the best chance to pass IRS muster.
WASHINGTON — Whenever you sell business or investment property and you have a gain, you generally have to pay tax on the gain at the time of sale. IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free.
The exchange can include like-kind property exclusively or it can include like-kind property along with cash, liabilities and property that are not like-kind. If you receive cash, relief from debt, or property that is not like-kind, however, you may trigger some taxable gain in the year of the exchange. There can be both deferred and recognized gain in the same transaction when a taxpayer exchanges for like-kind property of lesser value.
This fact sheet, the 21st in the Tax Gap series, provides additional guidance to taxpayers regarding the rules and regulations governing deferred like-kind exchanges.
Owners of investment and business property may qualify for a Section 1031 deferral. Individuals, C corporations, S corporations, partnerships (general or limited), limited liability companies, trusts and any other taxpaying entity may set up an exchange of business or investment properties for business or investment properties under Section 1031.
To accomplish a Section 1031 exchange, there must be an exchange of properties. The simplest type of Section 1031 exchange is a simultaneous swap of one property for another.
Deferred exchanges are more complex but allow flexibility. They allow you to dispose of property and subsequently acquire one or more other like-kind replacement properties.
To qualify as a Section 1031 exchange, a deferred exchange must be distinguished from the case of a taxpayer simply selling one property and using the proceeds to purchase another property (which is a taxable transaction). Rather, in a deferred exchange, the disposition of the relinquished property and acquisition of the replacement property must be mutually dependent parts of an integrated transaction constituting an exchange of property. Taxpayers engaging in deferred exchanges generally use exchange facilitators under exchange agreements pursuant to rules provided in the Income Tax Regulations. .
A reverse exchange is somewhat more complex than a deferred exchange. It involves the acquisition of replacement property through an exchange accommodation titleholder, with whom it is parked for no more than 180 days. During this parking period the taxpayer disposes of its relinquished property to close the exchange.
Both the relinquished property you sell and the replacement property you buy must meet certain requirements.
Both properties must be held for use in a trade or business or for investment. Property used primarily for personal use, like a primary residence or a second home or vacation home, does not qualify for like-kind exchange treatment.
Both properties must be similar enough to qualify as "like-kind." Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land. One exception for real estate is that property within the United States is not like-kind to property outside of the United States. Also, improvements that are conveyed without land are not of like kind to land.
Real property and personal property can both qualify as exchange properties under Section 1031; but real property can never be like-kind to personal property. In personal property exchanges, the rules pertaining to what qualifies as like-kind are more restrictive than the rules pertaining to real property. As an example, cars are not like-kind to trucks.
Finally, certain types of property are specifically excluded from Section 1031 treatment. Section 1031 does not apply to exchanges of:
While a like-kind exchange does not have to be a simultaneous swap of properties, you must meet two time limits or the entire gain will be taxable. These limits cannot be extended for any circumstance or hardship except in the case of presidentially declared disasters.
The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties. The identification must be in writing, signed by you and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary. However, notice to your attorney, real estate agent, accountant or similar persons acting as your agent is not sufficient.
Replacement properties must be clearly described in the written identification. In the case of real estate, this means a legal description, street address or distinguishable name. Follow the IRS guidelines for the maximum number and value of properties that can be identified.
The second limit is that the replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier. The replacement property received must be substantially the same as property identified within the 45-day limit described above.
It is important to know that taking control of cash or other proceeds before the exchange is complete may disqualify the entire transaction from like-kind exchange treatment and make ALL gain immediately taxable.
If cash or other proceeds that are not like-kind property are received at the conclusion of the exchange, the transaction will still qualify as a like-kind exchange. Gain may be taxable, but only to the extent of the proceeds that are not like-kind property.
One way to avoid premature receipt of cash or other proceeds is to use a qualified intermediary or other exchange facilitator to hold those proceeds until the exchange is complete.
You can not act as your own facilitator. In addition, your agent (including your real estate agent or broker, investment banker or broker, accountant, attorney, employee or anyone who has worked for you in those capacities within the previous two years) can not act as your facilitator.
Be careful in your selection of a qualified intermediary as there have been recent incidents of intermediaries declaring bankruptcy or otherwise being unable to meet their contractual obligations to the taxpayer. These situations have resulted in taxpayers not meeting the strict timelines set for a deferred or reverse exchange, thereby disqualifying the transaction from Section 1031 deferral of gain. The gain may be taxable in the current year while any losses the taxpayer suffered would be considered under separate code sections.
It is critical that you and your tax representative adjust and track basis correctly to comply with Section 1031 regulations.
Gain is deferred, but not forgiven, in a like-kind exchange. You must calculate and keep track of your basis in the new property you acquired in the exchange.
The basis of property acquired in a Section 1031 exchange is the basis of the property given up with some adjustments. This transfer of basis from the relinquished to the replacement property preserves the deferred gain for later recognition. A collateral affect is that the resulting depreciable basis is generally lower than what would otherwise be available if the replacement property were acquired in a taxable transaction.
When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.
You must report an exchange to the IRS on Form 8824, Like-Kind Exchanges and file it with your tax return for the year in which the exchange occurred.
Form 8824 asks for:
If you do not specifically follow the rules for like-kind exchanges, you may be held liable for taxes, penalties, and interest on your transactions.
Taxpayers should be wary of individuals promoting improper use of like-kind exchanges. Typically they are not tax professionals. Sales pitches may encourage taxpayers to exchange non-qualifying vacation or second homes. Many promoters of like-kind exchanges refer to them as “tax-free” exchanges not “tax-deferred” exchanges. Taxpayers may also be advised to claim an exchange despite the fact that they have taken possession of cash proceeds from the sale.
Consult a tax professional or refer to IRS publications listed below for additional assistance with IRC Section 1031 Like-Kind Exchanges.