Investors seeking financing of their replacement property in a 1031 exchange are sometimes presented with a dilemma. On the one hand, the same taxpayer that owns the relinquished property must acquire the replacement property. On the other hand, many lenders require borrowers to take title to the financed property in the form of a single purpose entity that only owns the replacement property and has never owned anything else. This article explains the basis of these contrary positions, and suggests an easy solution to this problem.

Same Taxpayer Rule

Investors can get deferral of capital gains tax on the sale of investment property by following the rules of Section 1031; however, in order to accomplish this, the same taxpayer that has disposed of the relinquished property needs to acquire the replacement property. This is true for two reasons.

First, if a different taxpayer acquires title to the replacement property, there really has not been an exchange of properties between the taxpayer and the intermediary. The taxpayer who is filing the tax return showing the sale of the property must exchange properties in a 1031 exchange in order to defer paying tax on the gain.

In addition, the property traded in an exchange has to be "like kind" and partnership interests are not exchangeable under Section 1031. Because of this, an investor who disposes of real estate in an exchange must acquire real estate and cannot acquire an interest in a partnership or an LLC.

Single Purpose Entity Requirement

Many lenders require their borrowers to take title to the property being financed in the form of a single purpose entity - in other words, an entity which has never owned anything before and only acquires the property being financed. This avoids problems with other creditors of the taxpayer, and is a bankruptcy protection strategy for lenders that is very common.

The Solution

An easy solution to this problem is the use of a single member limited liability company. A single member LLC is an LLC that has only one owner (commonly called the "member"). By default, a single member LLC is disregarded for tax purposes. This means that for income tax purposes it is as if the LLC does not exist. Nevertheless, for all other purposes the LLC does exist and therefore will serve as the single purpose entity desired by the lender.

For example, Tom Johnson owns several different apartment buildings and intends to acquire another one in a 1031 exchange. His lender requires that he take title to the new property in a single purpose entity, yet Mr. Johnson needs to acquire the replacement property in his own name for tax purposes in order to do a 1031 exchange. The solution is to form a single member limited liability company, Johnson LLC, to take title to the replacement property, with the sole owner being Tom Johnson. The lender will be happy because Johnson LLC has never owned anything except the replacement property, and Mr. Johnson will be able to complete his exchange because for tax purposes, the LLC is disregarded and it is as if Tom Johnson were taking title to the property in his own name.

When a husband and wife are acquiring property as community property, the IRS has said that they can be considered one person for this purpose. They can form one LLC and as long as the two of them are the only members of that LLC, it is disregarded for tax purposes. If the property is not community property, it is still advisable to form two separate single member LLCs.

References: Revenue Procedure 2002-69.