Don’t Handcuff Your 1031 Exchange

One of the most asked questions in 1031 exchanges involves property that was acquired by two or more people in a single limited liability company (LLC). Invariably, when the time comes for the parties to sell this property, one or more of them wishes to part ways with the rest of the crowd.

For example, Able and Ben acquired 123 Main Street in the name of ABC, LLC. In this particular instance, Able owns 55% and Ben owns 45% of the LLC. The time has come to sell 123 Main Street, and while each party wishes to participate in an IRC Section 1031 exchange, Ben wishes to part ways and acquire a property on his own. He has proposed that they dissolve ABC, LLC, and distribute the ownership of 123 Main Street to each of them in accordance with their ownership interests, as tenants in common, and that each participates in his own 1031 exchange.

The issue presented is whether this transfer of the relinquished property from the LLC to the individual taxpayers immediately prior to the exchange violates the “held for” requirement under Section 1031(a)(1).

The issue is that one of the basic eligibility requirements for a 1031 exchange is that the relinquished property must have been held for use as an investment property prior to the exchange. Many observers have opined that it is prudent that the property be rented out, at market rates, for at least 2 years before a 1031 exchange.

Basically once Able and Ben dissolve their partnership, they are now each trying to swap a property which has technically not been held for any amount of time and certainly hasn't  been held for long enough to qualify as being held for an investment property.

The statute itself is notably silent on this issue, but the IRS has considered this issue on several occasions. In fact, in rulings dating back 30 years, the IRS has consistently held that taxpayers structuring their deals in this fashion “did not hold the relinquished property for productive use in [their] trade or business, or for investment” as required by the statute. There have been a few cases that have been litigated, that disagreed with the IRS, where the courts have ruled in favor of the taxpayers. However, those cases were so limited in scope as not to apply to Abe and Ben’s transaction above.

An alternative strategy may be for ABC, LLC to sell 123 Main Street (for $1,000,000 for purposes of this example) as previously agreed by the parties, and to then acquire two new replacement properties. For their purposes, Able and Ben have each found property that suits their respective business plans. Able likes 55 Oak Street with a value of $550,000, and Ben likes 45 Maple Street with a value of $450,000. Note that the values coincide with their respective ownership interests in ABC, LLC.

ABC, LLC will now identify and acquire those two properties, within the rules and requirements of Section 1031, successfully completing its 1031 exchange. Thereafter, in a subsequent tax year, the parties may determine to dissolve ABC, LLC, distributing 55 Oak Street to Able and 45 Maple Street to Ben.

As with any legal matter, advance planning is the key to success. Our team of 1031 exchange attorneys, working with our clients and their legal counsel, have successfully guided our clients through 1031 exchanges involving this scenario on many occasions.

At Riverside 1031, our goal is to guide our clients and their advisors in maximizing the benefits of tax deferred exchanges. We seek to make every 1031 exchange smooth and worry-free. Let us help you navigate these, and other, 1031 exchange issues!

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