1031 Exchange Part 3 – Multiple Entities
By BPE Law Attorney Matthew Kirkpatrick
It is relatively easy to understand the concept in Exchanges that the Seller of the downleg property should be the same as the Buyer of the upleg property in order that the seller’s capital gains tax can be moved forward to their new property. This is generally called the Same Taxpayer Rule. It gets trickier however when title is held by different entities.
In a 1031 exchange, a taxpayer with multiple business entities could run into trouble when they want one entity to sell the downleg property and another entity to acquire the upleg property. The same taxpayer may own both entities but the property owners would be different…. there would be no continuity of title… and the Same Taxpayer Rule would be violated. Luckily, the IRS Regulations provide a solution: the Disregarded Entity.
Private Letter Rulings (“PLR”) are written by the IRS in response to inquiries by taxpayers concerning specific factual circumstances. Although PLRs are persuasive, they are not binding, precedential authority on the IRS or any courts. IRC §6110(k)(3). However, they are instructive in that they show how the IRS is likely to view specific facts patterns.
In a PLR from 2001, the IRS stated that “under the Regs an entity is generally disregarded as an entity separate from its owner if it has a single owner.” PLR 200131014. This would not apply to a corporation as it is a legal entity of its own. Unlike a partnership or LLC a corporation is not a pass-through entity and pays its own taxes. The Regs referred to state that “an eligible entity with a single owner can elect…to be disregarded as an entity separate from its owner.” Regs. §301.7701-3(a). Furthermore, the Regs state that, “in general, a business entity that has a single owner and is not a corporation … is disregarded as an entity separate from its owner for federal tax purposes.” PLR 200131014.
Therefore, if the taxpayer is the sole owner of a business entity, it will be a disregarded entity unless the taxpayer has actively elected otherwise and a taxpayer may sell the downleg property of one entity and purchase the upleg property with another entity.
Community Property Effects on Disregarded Entities
As we discussed previously, the IRS will allow a taxpayer to complete a 1031 exchange using different business entities to sell the downleg property and purchase the upleg property so long as they have a single owner. However, it is often the case that the business entities will be owned by husband and wife as community property. But, because of California’s community property laws, the IRS has provided assurances that entities solely owned by husband and wife will be treated as having a single owner.
Through Revenue Procedure 2002-69, which like a Private Letter Ruling are simply the policy of the IRS at the time they are written and subject to change at any time, the IRS laid out a three part test to determine if an entity will qualify for this treatment. It requires that “(1) The business entity is wholly owned by a husband and wife as community property under the laws of a state, a foreign country, or a possession of the United States; (2) No person other than one or both spouses would be considered an owner for federal tax purposes; and (3) The business entity is not treated as a corporation.” Rev. Proc. 2002-69.
In California this analysis is pretty straightforward. If the entities are wholly owned by a husband and wife in California the first two elements are satisfied. The only other issue is to determine if the entities would be considered a corporation by the IRS. Although there are many different entities that would qualify as a corporation (and disqualify an entity from this treatment) there are really only two important ones. The first is that the entity cannot be a corporation. The other is that the taxpayer cannot have designated the entity as an association which would pay its own taxes. For the most part, if you have an LLC and have not taken steps to designate it as a separate taxpaying entity, this element will be satisfied. If all the following are true, then the entity would be a disregarded entity and allowed to participate in a 1031 exchange.
If you would like to know more, please feel free to contact Matt by e-mail to firstname.lastname@example.org or call our main office at 916-966-2260 to schedule a low-cost Consultation appointment either in our Fair Oaks or Sun City Lincoln office.
The information presented in this Article is not to be taken as legal advice. Every person’s situation is different. If you are facing a legal issue of any kind, get competent legal advice in your State immediately so that you can determine your best options.