Don’t Let Ownership Change Derail Your 1031 Exchange Tax Deferral
One of the rules of a 1031 exchange is that the taxpayer who sells the relinquished property must be the same taxpayer who acquires the replacement property.
Why? Because the IRS views the 1031 exchange as a continuation of investment and not a reset. That continuity depends on the taxpayer and their investment capital staying the same throughout the process.
This is where things can get tricky.
Talk to Your CPA or Tax Advisor Before Your 1031 Exchange
Before you start the 1031 exchange process, you should work with your CPA or tax advisor. A common mistake we see is a taxpayer who sells the relinquished property in their individual name but then wants to acquire the replacement property with a new entity, sometimes a multi-member LLC. That move could disqualify the 1031 exchange.
Individual Seller? You Must Buy Individually
If you sell the relinquished property as an individual (e.g., Jane Smith), then Jane Smith must also be the purchaser of the replacement property. Buying in the name of a new multi-member LLC, such as “Smith & Jones Ventures, LLC,” would be viewed by the IRS as a different taxpayer. The result? Your 1031 exchange could fail, and you could be on the hook for capital gains taxes.
What About LLCs?
Understanding how LLCs are treated for tax purposes can help clarify what is allowed:
Single-Member LLC (SMLLC): This type of LLC is usually treated as a disregarded entity for federal income tax purposes. That means it is not considered separate from its owner, and all profits and losses flow through to the owner’s tax return. If Jane Smith owns 100% of “JS Holdings LLC,” then the IRS treats Jane Smith and JS Holdings LLC as the same taxpayer. A 1031 exchange can be completed in either name, as long as the ownership doesn’t change.
Multi-Member LLC (MMLLC): The IRS may treat MMLLCs as partnerships, which are regarded as separate taxpayers, and file IRS Form 1065 to report their income and expense. MMLLC can also be treated as corporations, either S-corp or C-corp, which file IRS Form 1120. If you sell real property as an individual but attempt to acquire the replacement property under a new MMLLC, the IRS may disqualify the 1031 exchange, because the entity receiving the replacement property is considered a different legal entity from you as the individual who sold the property.
Reminder: If the exchange funds from the sale of your relinquished property are tied to your individual name, they must be used exclusively by you (or your disregarded entity) to acquire the replacement property.
Key Takeaway: Maintain the “Same Taxpayer”
To preserve tax deferral benefits when doing a 1031 exchange:
Sell and buy the real property as the same taxpayer, either individual or entity
Don’t switch ownership structures mid-exchange if the entity is regarded as a different taxpayer
Keep your Qualified Intermediary and CPA informed of any entity involvement
Thinking about a 1031 exchange? Feel free to call me, Jeff Peterson, at 612-643-1031, or email me at jeffp@CPEC1031.com.
Defer the tax. Maximize your gain.
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