Internal Revenue Code (IRC) Section 1031 applies to the citizen or resident of the United States (US) or non-resident alien subject to US federal income taxes. When selling real and personal property held for productive use in a trade, business or for investment, a 1031 exchange allows individuals, partnerships, corporations, limited liability companies and trusts to defer the federal capital gain and recaptured depreciation taxes when selling property held for the proper intent, regardless of where the property is located. Property used predominantly in the US is eligible as replacement property held predominantly in the US, while property located outside the US is eligible for 1031 consideration with property held internationally.
Exchange Blog
1031 Exchange and Limited Liability Company
Often the titleholder or taxpayer considering a 1031 exchange is a single or multi member limited liability company when selling real or personal property held in the productive use of a trade, business or for investment. For those new to the term “1031 exchange,” the IRS 1031 code allows the taxpayer to defer the federal and state capital gains and recaptured depreciation tax when selling and replacing of equal or greater value, real or personal property held for the proper intent. The 1031 exchange represents an interest free loan that can exceed 40 percent of the asset selling price, which would otherwise be paid to the Treasury Department.
Same Taxpayer
One of the many 1031 exchange rules is the same taxpayer requirement, stating that the taxpayer who sells is the taxpayer who buys. A limited liability company (LLC) is quite often the taxpayer on title. According to the U.S. Small Business Administration ,“a limited liability company is a hybrid type of legal structure that provides the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership.” Owners are known as members. A single member LLC where the taxpayer is the only member is known as a sole or single member LLC. Profits and losses are passed through to the member and reported on the taxpayer’s federal return; consequently for federal income tax purposes the single member LLC is a disregarded entity.
Multi-member LLCs can also be formed where the members are individuals, corporations or other LLCs. Every state has a Limited Liability Company Act providing procedures to form and operate within its statutes. It is wise to consult with either your attorney or CPA when considering establishing a LLC to understand whether the formation of an LLC is to your benefit. Typically each state has a Department of State, Division of Corporations where Articles of Organization are created and annual reports submitted to maintain the LLC in good status. In Florida, www.sunbiz.org allows document searches to determine whether the LLC is active or not, as well as names of the members and address of the Registered Agent. Every state has a different fee to establish the LLC and file an annual report.
How do the following variations impact a 1031 exchange?
· Sole member
o A sole member LLC may sell or acquire the property in the individual’s name and vice versa.
· Husband and Wife
o A sole member LLC may sell and acquire the property as sole member LLC or individual and add spouse on to the replacement property deed as tenants in common.
o If husband and wife are on title selling property and reside in a community property state (Washington, Idaho, California, Nevada, Arizona, New Mexico, Texas, Louisiana and Wisconsin) one LLC can be established with the husband and wife as members to acquire the replacement property.
o If husband and wife are on title selling property and reside in a non-community property state and the intent is to title the replacement property in a LLC, then two LLCs are needed, one for the husband and one for the wife.
· Multi-member
o A two or multi member LLC owns a property and one member wants to cash out while the others want to defer the gain. Either the LLC is dissolved in a drop and swap, prior to entering the Purchase and Sale Agreement, dropping the members to their individual names as tenants in common as titleholders prior to the 1031 exchange or post exchange, or the LLC buys the cash desiring member out, known as “cross purchase,” with post exchange refinancing. The outgoing member is eliminated or reduced to a 1 percent member to maintain the LLC as a tax partnership.
Prior to establishing a LLC or a 1031 exchange, talking with your attorney or CPA is critical. If you own a property in a multi-member LLC, discuss with your partner their intentions to either cash out or to remain as members in the 1031 exchange. The earlier the steps are taken to drop and swap the better. Waiting just before the closing to decide jeopardizes the 1031 exchange given merit to the question whether the property is held for the proper intent by the new titleholders.
If you have questions, please click on the button below for a free consultation.
Contact Us
Atlas 1031 has been accommodating all types of exchanges for over 16 years. Should you have any questions regarding 1031 exchange rules and requirements as it pertains to ownership, please contact us through the consultation on this page or call our office at 800-227-1031. We look forward to hearing from you.
Vacation Home, Second Home and 1031 Exchange
Taxpayers seeking to defer federal and state capital gain taxes in a 1031 exchange when selling their vacation home must determine whether the sale qualifies for tax deferral treatment. Often times, the taxpayer wishes to engage a Qualified Intermediary, or QI, to accommodate the exchange, only to discover their vacation property has not been held as an investment property. The tax consequence, depending upon the realized gain, may be as high as 40 percent of the sales price.
IRS Penalty for Disallowed 1031 Exchange
In a 1031 exchange, a qualified intermediary (QI), accommodator or facilitator is engaged to provide exchange documentation and hold the exchange proceeds in an escrow account under the taxpayer’s tax identification number. Advice is provided to qualify the transaction as a 1031 exchange. For those accommodators who are not CPAs or attorneys, care must be given not to provide specific tax advice which subjects the accommodator to Circular 230 enrolled as agents who practice before the Internal Revenue Service. The QI is similar to a flagman warning a taxpayer driving along at 70 mph before a curve that the bridge not in view is out. Determining how to navigate the bridge is up to the taxpayer’s tax counsel, including their CPA and or tax attorney.
IRS Penalty Standards
When a 1031 exchange is audited and disallowed, the penalty standards include the income tax related to the sale of the relinquished property and the penalty and interest imposed on the underpayment of taxes, which is equal to the federal short term rate plus three percent. The accuracy related penalty is equal to 20 percent of the substantial understatement of the tax. A substantial understatement is defined as the greater of $5,000 or ten percent of the recognized gain.
Should the taxpayer have substantial authority for the disposition taken, the penalty can be avoided. Substantial authority is defined in Regulation Section 1.6662-4(d)(3)(iii) and based on the following:
(i) The Internal Revenue Code and other statutory provisions
(ii) Proposed, Temporary and final Regulations construing such statutes
(iii) Revenue Rulings and Revenue Procedures
(iv) Tax treaties and regulations thereunder and Treasury Department and other official explanations of such treaties
(v) Court cases
(vi) Congressional intent as reflected in committee reports, joint explanatory statements of managers included in conference committee reports and floor statements made prior to enactment by one of a bill’s managers
(vii) General Explanations of tax legislation prepared by the Joint Committee on Taxation
(viii) Private Letter Rulings and Technical Advice Memoranda issued after October 31, 1976
(ix) Actions on Decisions and General Counsel Memoranda issued after March 12, 1981 (as well as General Counsel Memoranda published in pre-1955 volumes of the Cumulative Bulletin)
(x) Internal Revenue Service information or press releases
(xi) Notices, Announcement and other administrative pronouncements published by the Service in the Internal Revenue Bulletin.
The penalty can be avoided if the relevant facts are adequately disclosed on the tax return and there is a reasonable basis for the position per Regulation Section 1.6662-4. In addition, the penalty can be assessed if there is negligence or disregard of regulations or rules per I.R.C. Section 6662(b). The taxpayer must maintain sufficient records to support their positions.
A fraud penalty is imposed of 75 percent of the underpayment if determined that taxpayer’s intent was to willfully evade the tax or to mislead.
I.R.C. Section 6701 levies penalties on persons who assist in the preparation of any portion of the taxpayer’s return knowing that such portion may result in an understatement of the tax liability. A $1,000 penalty is imposed; however, should a corporation tax return be subject to penalties, a $10,000 fine is assessed.
From a QI’s perspective who is not subject to Circular 230, knowing and acting within the boundaries of exchange advice is critically important. Telling the client they cannot provide tax advice protects the client and themselves. Taxpayers need to know the difference of what to expect and what not to ask. Ignorance is no excuse.
Should you like to receive “Taxpayers 1031 Checklist” inclusive of a checklist of 1031 issues to consider, click here for your free five page eBook.
Leasehold Improvement Tax Court Cases
Traditionally, the sale of real property exposes a taxpayer to a capital gains tax obligation if a gain was realized from the sale. Given the fact that capital gains tax rates have historically been high, taxpayers frequently look for ways to decrease or avoid paying capital gains taxes. One option allowable under the Internal Revenue Service Code is to enter into a Section 1031 Exchange in lieu of a traditional sale which results in a deferral of capital gains taxes. Section 1031 of the IRS Code provides that “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment.” For an exchange to qualify, the properties involved must be of “like-kind”. Not surprisingly, the definition of “like-kind” has been debated, argued, and expanded on by the Tax Court over the last 100 years in an attempt to decide whether the various transactions taxpayers have presented as Section 1031 Exchanges actually qualify. One variant of an Exchange that continues to result in confusion and litigation is the “leasehold Improvement” exchange.
Leasehold Improvements
A leasehold improvement involves modifications or renovations made to an existing building or piece of land that are made specifically to accommodate a business. Often, a taxpayer purchases a building or tract of land and then builds on the land or renovates the building to suit the taxpayer’s business purposes. If leasehold improvements are part of a proposed Section 1031 Exchange, they can complicate the analysis. This is particularly true if the taxpayer already owns the land on which taxpayer wishes to make the improvements prior to entering into the Section 1031 Exchange.
As a general rule, the I.R.S. has specifically disallowed attempts to use improvements of land already owned by taxpayer in a Section 1031 Exchange because a taxpayer cannot own both the property to be relinquished and the property used to replace it. Rev. Proc. 2004-51 Section 4.05 states “An exchange of real estate owned by a taxpayer for improvement on land owned by the same taxpayer does not meet the requirements of Code Section 1031.”
Disregarded Entity and 1031 Exchange
Often times, a taxpayer will choose to hold his/her investment property in the name of a disregarded entity or single member limited liability company (SMLLC), which allows the owner to be taxed on their personal tax return. The intent is that the owner’s personal liability is protected because the title of the property is held in the name of the SMLLC. Determining the merits of owning property in a SMLLC should be discussed with your tax and legal advisor.
1031 Exchange
A disregarded entity may still enter into a 1031 exchange and reap the benefits of deferred capital gains tax. When the owner is simply a single person, the process is quite simple. The same taxpayer requirement applies for a disregarded entity as it would if the property was owned in the name of the individual. The taxpayer who sells is the taxpayer who must acquire, with the exception of a disregarded entity. If held as a disregarded entity, then the taxpayer may acquire the replacement property or vice versa. The properties being exchanged must be held for investment or for trade or businesses, they must be of like-kind to one another, and the complete exchange must occur within 180 days of the sale of the old property. To defer the realized gain, the replacement property must be equal to or greater than the relinquished property, otherwise the difference is taxed.
Example: John holds his investment property, which he is selling for $200,000, in the name of an SMLLC for liability purposes. He acknowledges that he will be completing a 1031 exchange. John may purchase the replacement property as an individual or in the name of the disregarded entity. The new property’s purchase price is $250,000. Any capital gains tax that would be due from the sale may be deferred because John or the disregarded entity is re-investing 100 percent of the sales proceeds into the new property.
Drop and Swap
Taking the disregarded entity a step further, a 1031 exchange can carefully be completed with a multiple member limited liability company (MMLLC). Sometimes partners in an investment may disagree on the use of the proceeds from the sale of their shared interest. One partner may want to complete a 1031 exchange and re-invest the proceeds with no capital gains tax, while the other may want to cash out and move on. The so-called “drop and swap” can be an option in this situation. Prior to the sale of the old property, the partnership of the MMLLC will be dissolved and will distribute the property as tenant in common interests to each individual member. This is the “drop” in the transaction because the MMLLC is dropping to individual’s names. The sales contract needs to be entered into as tenants in common. Because the ownership structure is now tenants in common, upon the sale of the old property, one partner may exchange his/her interests into a replacement property, while another partner may decide to cash out and be liable for the capital gains tax.
A “drop” and “swap” can have its risks. Dropping the property to tenants in common status should be done a year in advance to ensure that the property will qualify for 1031 status. This is not a hard-and-fast rule, but the Internal Revenue Service (IRS) will likely look more closely if the drop occurred less than 12 months prior to the sale. Another aspect the IRS will potentially put a microscope to is the operation. Once the “drop” occurs, any activity must follow that of tenant in common interests and not as a partnership. Once again seek the counsel of your tax advisors to understand the tax consequences and risks.
Disregarded Entity
The primary reasons to hold property in a disregarded entity are protection of personal assets and reduced tax filing expense using Schedule C by the taxpayer. A subchapter S corporation is not considered a disregarded entity though the taxpayer is taxed on their personal return filing IRS Form 1120-S. A partnership is not a disregarded entity nor is a multi member limited liability company. A corporation is a separate entity from the taxpayer and is not a disregarded entity. The disregarded entity is ignored for federal and many state income tax purposes.
We Can Help
Atlas 1031 Exchange has been accommodating tax-deferred exchanges of all kinds for more than 17 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange.
Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.