A disregarded entity may sound like a complex term, but if you're familiar with pass-through entities, you're already familiar with disregarded entities. There's a little more to know about a disregarded entity, though, which is what we'll go over in this article.
What Is a Disregarded Entity?
A disregarded entity does not file a tax return. Income and expenses flow through the disregarded entity to the investor or owner of the entity. This component of a disregarded entity is a legal rather than a financial structure. Its legal aspect is the protection of the investor or owner of the entity.
Because a disregarded entity doesn’t file a tax return, it also doesn’t pay federal taxes. The tax burden goes to the entity member or owner. Income and expenses of the disregarded entity go onto Schedule C of the sole member’s Federal Form 1040 tax return.
Types of Disregarded Entities
Several entities fall under the category of disregarded entities. These include the following:
- Revocable living trusts
- Land trusts
- Single-member limited liability companies
- Delaware Statutory Trusts (DSTs)
Disregarded Entity and Delaware Statutory Trusts (DSTs)
A DST is like a combination of a land trust and a single-member LLC. A land trust hides its members while an LLC protects them. Investors in a DST are basically hidden since they do not show up on property titles. They are also protected from liability.
As a pass-through entity, a DST passes tax consequences on to its investors. Taxes owed by investors are based on their share (percentage) of ownership. Because taxes pass through, a DST does not incur a tax liability.
The Disregarded Entity's Role in a 1031 Exchange
For a 1031 exchange to be successful, the relinquished and acquired properties must fall under the same tax return. This means if an LLC relinquished property in a 1031 exchange, the same LLC must acquire the replacement property. On the other hand, if an LLC relinquishes a property, but an individual (member of the LLC) acquires the replacement property, the 1031 will be invalid.
Disregarded entities have special characteristics that apply to a 1031 exchange. Particularly for the revocable living trust (RLT)¹, if an individual holds property within the trust, it is the trust that holds the title. Thus, when the owner files a tax return, the property shows up on the individual's return since the RLT does not file a tax return.
Above, we mentioned that the property exchange must occur under the same tax return. In the RLT example, the individual can relinquish the property and acquire another under his tax return, even though the relinquished property was held in the trust. The acquired property does not involve the trust in this example.
In summary, disregarded entities have three main characteristics that make them stand out from other entity types:
- Do not file tax returns
- Provide liability protection to investors/owners
- Hide investors/owners since it is the disregarded entity that holds title to the property rather than the investors/owners
While investors do not hold title to property in a DST, they do own the property based on their percentage investment.
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. 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.