How to Complete a 1031 Exchange for an LLC

A 1031 exchange allows real estate investors to defer capital gains taxes by reinvesting the proceeds from a sold property into a new, like-kind property. Many investors hold properties within a Limited Liability Company (LLC) for asset protection and operational flexibility. However, executing a 1031 exchange for a property held by an LLC, particularly one with multiple members, introduces challenges that require careful planning.

Understanding the Core Challenge for LLCs

The main challenge for a multi-member LLC (MMLLC) in a 1031 exchange is its tax classification as a partnership. The Internal Revenue Code states that partnership interests are not “like-kind” property and are ineligible for an exchange. This means an individual member cannot simply sell their share of the LLC and use the proceeds to buy a new property in a tax-deferred exchange.

The exchange must be made by the same taxpayer who sold the original property. For an MMLLC, the partnership itself is the taxpayer that owns the real estate, not the individual members. If the LLC sells a property, the LLC must also acquire the replacement property for the exchange to be valid. This creates a problem when some members want to perform an exchange and others wish to cash out their investment.

The process is simpler for a Single-Member LLC (SMLLC), which the IRS treats as a “disregarded entity.” Its activities are reported on the owner’s personal tax return, allowing the sole member to execute a 1031 exchange without the complications faced by partnerships.

Structuring Options for Multi-Member LLCs

The “Drop and Swap”

One strategy is the “drop and swap,” where the LLC distributes ownership of the property to its members before the sale. The LLC dissolves and deeds the property to the members, who then hold it as Tenants-in-Common (TICs). As direct owners, each member can independently decide whether to initiate their own 1031 exchange or sell their fractional interest and pay capital gains tax.

This structure provides flexibility when members have different investment goals but requires careful timing. The IRS requires that the property be “held for investment” by the taxpayer performing the exchange. If the “drop” occurs immediately before the sale, the IRS might argue the members did not hold the property for investment as TICs. To demonstrate investment intent, many tax advisors recommend holding the property as TICs for a significant period before the sale.

The “Swap and Drop”

In a “swap and drop,” the LLC executes the 1031 exchange by selling the property and acquiring a replacement property. After the exchange is complete and a suitable holding period has passed, the LLC then distributes the new property to its members. This method ensures the “same taxpayer” rule is met because the LLC handles the entire exchange.

This approach has less risk of an IRS challenge compared to the “drop and swap.” The main consideration is that all members are tied into the exchange process together. The LLC must collectively agree on a replacement property, which can be challenging if members have differing opinions. Following the exchange, the subsequent distribution of the new property must also be carefully planned.

Member Buyout

A straightforward option is for members who wish to perform an exchange to buy out the interests of members who want to cash out. This transaction occurs before the property is sold. By purchasing the other members’ interests, the remaining group consolidates ownership, which may result in the LLC becoming a single-member entity.

Once ownership is consolidated, the LLC can proceed with the 1031 exchange as a unified entity. If the buyout results in a single-member LLC, the process becomes much simpler. The funds for the buyout must come from the purchasing members, not from the proceeds of the eventual property sale.

Partnership Division

A more complex strategy is a partnership division, which involves dividing a single partnership into two or more new partnerships before the exchange. The original LLC’s assets are allocated among the new LLCs based on the members’ goals. For instance, members wanting to exchange can be grouped into one new LLC, while members wanting to cash out are grouped into another.

The new LLC containing the members who wish to exchange can then sell its property and conduct a 1031 exchange. This method formally separates the members and their assets, providing a clean structure. It is generally reserved for more complicated or high-value transactions and requires significant legal and accounting expertise.

The 1031 Exchange Timeline and Rules

Executing a 1031 exchange requires adherence to a strict timeline and set of rules, facilitated by a Qualified Intermediary (QI). A QI is an independent party who holds the sale proceeds from the relinquished property and uses them to acquire the replacement property. At the closing of the relinquished property, the closing agent will be instructed to wire the net proceeds directly to your QI, as it is a requirement that you not have actual or constructive receipt of the funds.

The exchange timeline begins on the day the relinquished property is sold. From that date, you have 45 days to provide your QI with a written, signed Identification Notice. The delivery method should be verifiable to prove it was sent within the deadline; options include certified mail, an overnight courier, or email if your QI agreement permits it and you receive a dated confirmation.

You must adhere to specific identification rules. The “3-property rule” allows you to identify up to three properties of any value. The “200% rule” lets you identify more properties as long as their total value does not exceed 200% of the relinquished property’s sale price.

The entire exchange must be completed within 180 days of the sale of the relinquished property, or by the due date of the tax return for that year, whichever is earlier. To acquire your chosen replacement property, you will enter into a purchase agreement and assign your rights in that contract to the QI. The QI will then use the exchange funds they have been holding to purchase it on your behalf, and the title will be deeded directly to your LLC.

Tax Reporting and Basis Considerations

IRS Form 8824

After completing a like-kind exchange, you must report the transaction to the IRS by filing Form 8824, “Like-Kind Exchanges,” with your LLC’s tax return. You will need to provide descriptions of the properties exchanged, dates of identification and acquisition, and the relationship between the parties involved. The form is used to calculate the amount of gain that can be deferred.

Calculating “Boot”

In a 1031 exchange, any property received that is not “like-kind” is considered “boot” and is taxable. Boot can come in the form of cash received or debt relief, which occurs when the mortgage on the replacement property is less than the mortgage on the relinquished property. For example, if the mortgage paid off on your old property was $500,000 and the new mortgage is $400,000, you have received $100,000 in mortgage boot, which is taxable unless offset by adding equivalent cash to the purchase.

Determining New Property Basis

A 1031 exchange affects the tax basis for your new property. The basis is not its purchase price; it is adjusted to account for the deferred gain. A common way to calculate the new basis is to take the fair market value of the replacement property and subtract the gain that was deferred from the sale of the old property. For instance, if you acquire a new property worth $1 million and deferred a $300,000 capital gain, your new adjusted basis in that property is $700,000. This lower basis will be used for future depreciation and to determine your capital gain when you eventually sell the new property.