As published in Scotsman Guide's Commercial Edition, July 2005.
Real estate like-kind exchanges would be far simpler if they only involved the sale of relinquished property and the acquisition of replacement property without the issues raised by financing. However, that is much like asking a bus to stop at your front door when the bus stop is down the street. It might be convenient, but it’s not likely to happen.
Financing is the fuel of real estate. It increases returns from limited equity. But issues arise when using financing as part of an exchange. One issue is the segregation of money. To qualify for nonrecognition treatment under Section 1031 of the US Tax Code, the money used to purchase the replacement property must consist of proceeds received from the sale of the relinquished property. In other words, it must be clear that the proceeds are 1031 funds. Once that is determined, the financing may proceed. A simple way to think of it is to exchange first and subsequently finance the property. To ensure the validity of the exchange, it is essential to document the source of funds (1031 vs. financing).
Another issue is the taxpayer’s ownership of the relinquished and replacement properties. A critical requirement of like-kind exchanges is that the taxpayer must own the relinquished property and the replacement property. But a familiar criterion of current real-estate loans, especially in the capital-markets era, is the requirement that the title-owning entity be a special-purpose, bankruptcy-remote entity. These issues are managed through an appropriately structured, single-member, limited- liability company.
Single-member, limited-liability companies
Under the treasury regulations, state-law-entity classifications do not govern the treatment of entities. For this reason, a business entity with two or more owners can choose to be classified as either a partnership or an association for federal income tax purposes (and as an association, it is treated as a corporation). On the other hand, a business entity with only one owner may elect to be classified for federal income tax purposes as an association or an entity disregarded from its owner.
The default rule for a single-owner entity is that it is disregarded. The benefit of choosing disregarded treatment is that the assets and liabilities of the single-owner entity are treated as the assets and liabilities of the single owner. If the taxpayer in a like-kind exchange acquires the replacement property through a single-member, limited-liability company, it is as if the taxpayer alone acquired the property.
But lenders also require the borrower entity to be bankruptcy-remote. This requires a single-member, limited-liability company to be protected against the risk of dissolution of the sole member by the addition of another member. But with two members, the limited-liability company becomes either a partnership or an association. Under either classification, the 1031 taxpayer is not considered the owner, and the exchange fails.
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