1031 Exchanges Using LLCs

Thanks @Sharon Tzib for your comment on my previous post regarding new investors using LLCs. You are correct that you have to be very careful how you use a LLC in a 1031 exchange. I thought it would be useful to summarize when you can and when you can't use a LLC in a 1031 Exchange.

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The rule on 1031 exchanges is that the party that starts a 1031 exchange must be the same party that finishes it. So, I could not sell a property that I own as an individual and buy a replacement property using an LLC that is owned 50/50 by me and my brother because the party that sold the property (me) is not the same party that bought the property (the LLC).

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Question #1: Can I sell a property that I own individually and buy a property using a newly formed LLC that I own 100%?

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Answer: Yes, under the tax code, a LLC with one owner is considered to be "disregarded" for tax purposes and owned 100% by its owner. Therefore, the party buying the property is the same as the party selling the property.

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Question #2: Can my spouse and I sell a property that we own personally and buy a replacement property in a LLC that is owned by both of us?

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Answer: It depends - If you live in a community property state (Texas, California, Washington, Arizona, Wisconsin, Nevada, Louisiana, Idaho and New Mexico), the answer is yes. If you live in any other state, the answer is no. This is due to a special rule under Revenue Procedure 2002-69 that states that a LLC owned by a husband and wife in a community property state is also considered to be a disregarded entity and for tax purposes, the property is treated as if it is owned directly by you and your spouse. So, the party that started the 1031 exchange is the same party that completed it.

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Question #3: Can my sister and I buy a property in our personal names, drop it into a LLC and eventually do a 1031 exchange on this property?

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Answer: Yes. But the party doing the exchange needs to be the entity itself. So, the LLC would sell the property and purchase the replacement party. The fact that the original purchaser was different than the party doing the 1031 exchange does not matter. The only thing that matters is that the party that starts the exchange is the one that completes the exchange.

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Question #4: I own a small interest in a LLC that invests in a large multifamily property. Can I do a 1031 exchange to sell this LLC interest and buy a LLC interest in another property?

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Answer: You cannot exchange one LLC or partnership interest for another LLC or partnership interest and defer the gain using a 1031 exchange. For example, one member of the LLC cannot decide to do a 1031 exchange on their interest only without the entire LLC disposing of their interest. (NOTE: It is possible to work around this by using a "swap and drop" or "drop and swap" strategy if all members/partners are willing. See your tax advisor for details on this strategy.)

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Hopefully this helps clarify some of the issues with LLCs and 1031 exchanges. Feel free to PM me with specific questions or add additional comments to this post.