Last updated on February 18th, 2021 at 09:10 am
Using a 1031 exchange involves exchanging one investment property for another without incurring immediate liability to pay any capital gains taxes on the property transactions. One of the key requirements of a 1031 exchange is that the same investor must be involved in both transactions. That means that the seller of the original investment property must also be the purchaser of the subsequent investment property that is part of the 1031 exchange.
While the 1031 exchange requirements must be strictly followed in order to reap the significant tax advantages of this structured real estate transaction, this investment option is available to a broad range of individuals and entities. Just as an individual investor may participate in a real estate transaction as a 1031 exchange, so can a single-member limited liability company (LLC). The mechanics of a 1031 exchange involving a single-member LLC are explained in more detail below.
What is a Single-Member LLC?
A single-member limited liability company is typically formed so that the individual owner of the corporate entity is not held personally liable or responsible for the entity’s transactions. The owner of the LLC is referred to as a member for legal and tax purposes. Even though the member is the only owner, a single-member LLC must still complete all required business registration filings for their particular state in order to be considered a legitimate LLC.
For the purpose of filing your tax return, a single-member LLC is a disregarded entity, which means that the individual owner completes and files a Schedule C for reporting their LLC business income to the IRS. The times when a single-member LLC would not be treated as a disregarded entity by the IRS include if the LLC has any employees to whom it pays a salary, which means that it would have to pay applicable employment taxes and also excise or use taxes.
Form 8832 allows a corporate entity to declare how it should be treated for tax purposes. The filer can choose to be treated as a disregarded entity if it is a single-member LLC or a corporation by selecting the appropriate box on Form 8832. In the absence of any election otherwise, a corporation will be treated as a disregarded entity if it is a single-member LLC.
How Does a Single-Member LLC Participate in a 1031 Exchange?
Per §301.7701-(3)(b)(1) of the Treasury regulations, a single-member LLC is treated as a disregarded entity for tax reporting, which means that the LLC owner is considered the owner of any real estate purchased through the LLC. This also allows the individual owner who purchased the original property to be sold in a 1031 exchange to form a single-member LLC for purposes of acquiring the replacement real estate in the exchange without taking the transaction outside of the 1031 exchange parameters.
The rules regarding a single-member LLC and individual ownership status are fairly flexible when it comes to a 1031 exchange. For example, according to IRS Letter Ruling 200131014, an individual may take the title of the replacement 1031 real estate and then later form a single-member LLC that holds title to the replacement property without violating the 1031 exchange requirements.
Final Thoughts on How a Single-Member LLC Can Participate in a 1031 Exchange
In sum, the 1031 exchange framework can be used to defer capital gains tax liability for a broad range of corporate entities and individuals. The registration of a single-member LLC by an individual investor executing a 1031 exchange does not affect the tax liability of the transaction itself, although it is important to seek professional counsel to ensure that the real estate transaction has been structured according to all applicable 1031 exchange requirements. Failure to abide by those regulations can result in unexpected and significant tax liability.