You have a variety of business entities from which to choose when it comes to initiating and completing a 1031 exchange. According to the IRS, individuals, C corps, S corps, general or limited partnerships, limited liability companies, and trusts – basically, any type of taxpaying entity – can set up to exchange investment properties under 1031 exchange rules.
Then there is the disregarded entity. A disregarded entity doesn’t mean that it’s prohibited from participating in a 1031 exchange. It’s just a different legal structure for participating in a 1031 exchange.
One of the mandates of a 1031 exchange is that the relinquished property and the replacement property must be under the same name. In other words, you can’t sell a relinquished property under one LLC – like “Smith Company” – and claim the replacement property under another – like “Jones LLC.” Smith Company (or Jones LLC) must let go of the relinquished property and take ownership of the replacement property.
The exception is when you form a disregarded entity. A disregarded entity is set up as a separate legal entity that ensures limited liability for you. But from the IRS’s perspective, that entity, which has your tax identification number, is considered part of your activity.
Disregarded entities can be formed under the following conditions:
Single-Member LLC
If you’re a single-owner investor, you might want to hold title to your replacement property in the name of an LLC to protect against any liabilities or damages. This means that if you hold title to the relinquished property as Ben Smith, you can buy and hold the replacement property’s title under the name of Smith LLC. That is, as long as you haven’t elected to be otherwise taxed.
Revocable Living or Grantor Trust
A similar disregarded entity scenario is in play when it comes to certain types of trusts. You might want to own an exchange replacement property under the name of Smith Trust. Or perhaps Smith Trust owns the relinquished property, but you want the replacement property owned outside the trust.
In either case, Smith Trust is considered the disregarded entity in the eyes of the IRS. Again, this helps with liability protection.
Delaware Statutory Trust
The DST can provide multiple investment benefits if you’re interested in real estate ownership. Furthermore, under certain situations, the IRS views a DST as a disregarded entity for federal income tax purposes. This means that, as long as you follow the IRS’s specific rules, you can exchange your real property for an interest in the DST. It also means that you benefit from the same liability protection as a Delaware corporation’s shareholders.
The main benefit of a disregarded entity is limited liability protection, pass-through taxes (so you’re not double-taxed), and in some cases, easier tax filing processes. To determine if forming and maintaining a disregarded entity is the right step for your 1031 exchange and to ensure that you set up the entity properly, be sure to talk to a qualified tax professional and/or attorney.
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.
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.
Hypothetical examples shown are for illustrative purposes only.
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.
