LLC Issues in 1031 Exchanges: Insights from Revenue Rulings 99-5 and 99-6

Ownership of real property in a limited liability company (“LLC”) has become commonplace for a variety of factors ranging from liability considerations to handling of finances and management. When it comes to an LLC that has more than one member, investors often face challenges when looking to do a 1031 exchange. A multi-member LLC is treated as a partnership for income tax purposes. Because the IRS specifically excludes partnership interests from exchange treatment in Internal Revenue Code § 1031(e), this means that partners selling property cannot all go their separate ways, with some exchanging and others cashing out of a sale. The entire partnership must exchange, or the partners can examine workarounds such as the drop and swap. However, there are certain scenarios involving LLCs and multiple members where an exchange into or out of a partial interest in real estate, held through an LLC, may in fact be possible. These notable exceptions are provided in Revenue Rulings (“Rev. Rul.”) 99-5 and 99-6 and can offer strategic avenues for investors in similar circumstances.

Sale or Purchase of an Interest in an Existing Single-Member LLC

In Rev. Rul. 99-5, the IRS addresses a scenario where a taxpayer, who owns property through a single-member LLC, will be selling an interest in the LLC to a buyer. The taxpayer is considered the owner of the underlying property for income tax purposes, through their LLC, because as a single-member LLC it is treated as disregarded for federal income tax purposes. When the taxpayer transfers a portion of the LLC interests to the buyer, they are treated for tax purposes as though they directly sold their interest in the underlying property (and that transfer qualifies for a 1031 exchange). The buyer and taxpayer are treated as then contributing their respective interests in the property to the LLC, as a new partnership. In other words, an investor that owns property in their wholly-owned LLC can sell an interest in that entity to a buyer, and conduct a 1031 exchange with the proceeds of the sale, because they are considered to own the underlying property and are thus selling an interest in it – rather than a partnership interest. By contrast, in the sale of a property by an LLC with two existing partners, a partner of the LLC could not do their own exchange with proceeds from the sale because they are not considered the tax owner of the property – they instead own an interest in personal property (a partnership interest). The Rev. Rul. also indicates that a buyer like the one they describe who is considered to first be purchasing the taxpayer’s underlying interest in the real property, and then contributing it to the new partnership, could use that purchase as replacement property in an exchange. What this means is that an exchanging investor may be able to purchase a partial interest in an LLC in order to acquire an interest in the underlying property, if they’re purchasing that interest from the member of a wholly owned LLC that is treated as disregarded for federal income tax purposes.

Purchase of Interests in an Existing Multi-Member LLC

In Rev. Rul. 2004-77, the IRS established that an LLC will be treated as disregarded for federal income taxes when it has multiple members, if each of those members in turn is ultimately the same taxpayer (i.e., there is only one ultimate taxpayer that owns the LLC). In Rev. Rul. 99-6, the IRS leaned on this prior ruling to determine that a taxpayer who purchases an interest in an LLC that it already owns an interest in, such that it becomes the sole owner of the entity, will be treated as purchasing an interest in the underlying property directly. The Rev. Rul. detailed that the limited partnership will be considered terminated, and to have made a liquidating distribution to its partners; meanwhile, the taxpayer is treated as contributing the asset they directly acquired to the new single-member LLC (treated as disregarded for income tax purposes). To that end, an investor in a partnership that owns property through an LLC could buy out the other partners and use the purchase of their interest(s) as replacement property in a 1031 exchange. Something to note, however, is that the bought-out partners are considered to be distributing partnership interests in this scenario. They would not be able to exchange out of their sale of membership interests to the buyer.

Conclusion

Rev. Rul. 99-5 and Rev. Rul. 99-6 provide unique opportunities for real estate investors with transactions involving LLCs to utilize 1031 exchanges effectively, despite the general restrictions on exchanging partnership interests. These rulings allow for creative structuring of transactions that still meet the requirements of 1031 exchanges, providing significant tax deferral benefits. Investors should consult with their tax and legal advisors to fully leverage these opportunities and ensure compliance with IRS regulations.

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