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With increasing regularity, a taxpayer ("Exchanger") who wishes to transact a tax-deferred exchange under IRC Section 1031 (a "1031 Exchange") is confronted with a seemingly insoluble dilemma. Exchanger transfers the property he is disposing of in the 1031 Exchange (the "Relinquished Property"). Exchanger then contracts for the purchase of the property he wishes to acquire in the exchange (the "Replacement Property") only to find that all lenders require that title to the Replacement Property be taken in a single asset entity, preferably a limited liability company (an "LLC"). Why should this present a problem? For one thing, in a 1031 Exchange, title to the Replacement Property must be acquired by the same person or entity which has disposed of the Relinquished Property. For example, no tax deferral will result if an Exchanger disposes of the Relinquished Property held in his name and title to the Replacement Property is taken in the name of his child, friend or even his closely held corporation. Chase v. Comm., 92 TC 874 (1989). For another thing, an interest in an entity generally is deemed to be personal property and real property is not "like kind" to personal property. Rev. Rul. 59-229, 1959-2 CEB 180. There is a statutory exception to this rule. IRC Section 1031 (a) (2) expressly provides that an interest in a partnership will be treated as an interest in its assets if an election under IRC Section 761 (a "761 Election") has been made. A 761 Election may be made by any partnership whose activities are limited to investment purposes and not the active conduct of a trade or business, as long as the partners each have the right to take their share of the property held by the partnership. IRC § 761. Congress has deemed an interest in a real estate partnership which has made a 761 Election (a "761 Partnership") to be like kind to an interest in real property because such an election results in the partnership being totally disregarded for tax purposes. The partners, therefore, directly own pro rata interests in the real property assets of a 761 Partnership. There are two significant drawbacks to the making of a 761 Election. First, if real property owned by a 761 Partnership ultimately is sold at a loss rather than at a gain, the loss probably will be treated as a capital rather than as an ordinary loss. See Yarbro v. Comm., 737 F2d 479 (5th Cir.) 1984, 84-2 USTC 9691, cert denied 469 US 1189. Furthermore, since each partner must have the right to take his share of the property, any partner can thwart all the others with regard to sale or refinance of the property. For these reasons, it is unusual for an Exchanger to trade out of a Relinquished Property which he alone owns and to acquire an interest in a 761 Partnership. LLCs increasingly are supplanting partnerships as the investment vehicle of choice. Not only do the members of an LLC have wide latitude in selecting the tax treatment of the LLC, an LLC generally is easier to form and maintain and provides greater insulation from liability than does any partnership, limited or general. The formal requirements for LLCs, as for partnerships and corporations, are governed by the laws of the state in which they are formed. Thus, for example, LLCs formed under California law must have at least two members while LLCs formed in Nevada, Texas, Delaware and certain other states permit an LLC to have only one member. California law permits California residents owning property located in California are permitted to form an LLC governed by the laws of a different state. Corp. Code § 17450. The question of how many members an LLC must have is important because the regulations issued by the Treasury Department provide that, for tax purposes, a single member LLC is disregarded as an entity separate from its owner unless it elects to be taxed as an association. Reg Section 301.7701-2 and 3. The owner of an LLC which is disregarded for tax purposes is in the same position economically as a partner in a 761 Partnership. Conceptually, therefore, the owner's interest in a single owner LLC should be like kind to real property just as is a partner's interest in a 761 Partnership! Fortunately, the IRS appears to concur with this reasoning, as in 1997 it issued a private letter ruling arising under the following facts. A parent corporation and two subsidiaries each transferred a Relinquished Property as part of their intended 1031 Exchanges. Subsequently, both subsidiaries merged with the parent corporation, which then formed three single member LLCs, each of which acquired one Replacement Property. The IRS approved the exchange, ruling that the parent will be treated for tax purposes as both the transferor of the Relinquished Property and the transferee of the Replacement Property. Ltr Rul 9751012. In 1998, the IRS issued another favorable private letter ruling on similar facts. In that ruling, the Exchanger was a limited partnership. The precise type of entity formed to acquire the Replacement Property was not stated, but it is a business entity having the same tax status as a single member LLC. The IRS ruled that the Exchanger's receipt of the Replacement Property by that entity would be treated as the receipt of real property directly by Exchanger. Ltr Rul 9807013. A private letter ruling is binding upon the IRS only as to the particular taxpayer to whom it is issued and it may be modified or revoked even as to that taxpayer. It may not be cited as precedent by any other taxpayer and the IRS can take a position contrary to that expressed in the ruling at any time. Thus, although the two letter rulings discussed above indicate the current thinking of the IRS, they offer no assurance that the IRS will continue to adhere to the conclusions and the reasoning of those rulings. We do not yet have a definitive answer as to whether an Exchanger can trade real property for an interest in a single owner LLC. However, we now have a very promising approach which is conceptually sound and is currently in favor with the IRS. Hopefully, Congress, the IRS or the courts will expressly sanction this approach.
Copyright © 1998 Richard A. Goodman |