In the world of business ownership and property investments, there are several different structures and tools that you can use. For instance, you can own a business as a sole proprietor, you can have co-owners, and you can all be in business together as an LLC. In an LLC, you and the people you own the business with have a legal separation of your personal finances and the business’s finances. This ensures that you are not at risk of personal financial ruin if the business doesn’t work out as you planned.
In addition to knowing how to use tools such as LLCs to protect you and your business partners, it’s also important to understand how to utilize tools that allow you to offset your tax earnings in a legal manner. For LLCs who own real estate holdings, one such example is the 1031 Exchange. Understanding the legalities surrounding how 1031 Exchanges work within an LLC is crucial when acting both legally and ethically.
What is an LLC?
An LLC, which stands for “Limited Liability Corporation,” is a business structure in which the owners separate their personal finances from those of the business. Under this structure, none of the owners are personally or financially responsible should the business fail. It’s a popular choice among business owners in all industries, including real estate, as many entrepreneurs simply don’t want to face financial ruin should their business fail.
What is a 1031 Exchange?
A 1031 Exchange, also called a “like-kind exchange,” is a powerful tool that real estate investors have relied on for years. Within this option, investors can essentially trade one piece of commercial real estate for another property, as long as it meets the definition of "like-kind" property set forth by the IRS. When a commercial real estate investor sells a piece of property, he or she has a predetermined amount of time to use those funds to purchase another property without being legally obligated to claim the income generated by the property’s sale on their taxes for that year.
Can a Member of an LLC Do a 1031 Exchange?
The answer to this question depends on how your LLC is structured. Remember, LLCs and partnerships are different, so there are some cases where you can do a 1031 Exchange as an LLC. However, it depends on the LLC’s structure. If you are a solo real estate investor and the sole member of the LLC, you have every right to sell a subject property and then use those funds to purchase another, claiming a 1031 Exchange on your taxes for the year.
If the LLC as a whole wants to do a 1031 Exchange on a piece of property, that is permissible, given that the LLC performs the 1031 Exchange on an entity level. Under this concept, the entire LLC would relinquish the ownership of a property before choosing a new property of equal or greater value that the entire LLC wants to purchase. This would obviously be done in order to prevent the LLC from having to pay capital gains taxes on the property that was sold within the tax year.
However, what happens if there are multiple owners of the LLC, and therefore, multiple owners of the subject properties that the LLC owns? The classification of real estate holdings within a partnership makes it impossible for a single member of the LLC to sell their interests in a property before using those funds to purchase another property under a 1031 Exchange. LLC holdings are considered “personal property” and ineligible to be used in a 1031 Exchange. If you own a property with multiple partners, you can sell your share. However, you will be forced to claim the profits generated on your taxes for that year.
One of the most important aspects of owning an LLC and real estate investing is doing so within the framework of the law. Failure to comply with tax laws can result in heavy financial penalties and possible prison time.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities. All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure. Cash flow or income are not guaranteed.
