A 1031 Exchange, per Internal Revenue Code (Internal Revenue Code) Section 1031, permits investors to sell real estate and trade into a “like kind” property while deferring capital gains. This tool has long been used by investors to increase their returns, reduce their tax burden, and ultimately build their wealth. However, the Internal Revenue Service (IRS) has outlined strict guidelines for a 1031 Exchange, including who is authorized to engage in an exchange.
Individuals, C corporations, S corporations, partnerships (general and limited), limited liability companies (LLCs), trusts, and any other tax-paying entity may qualify for a 1031 Exchange. Yet, when a property sells, the same individual or entity on the title of the relinquished property must be on the replacement property or properties for the exchange to qualify.
As mentioned, an LLC is permitted to do a 1031 Exchange. However, this means that all members of the LLC must have an exit strategy that aligns. When members differ in their decision for exiting the property, problems can arise, which can also result in a financial burden for some members. When some members want to sell and cash out, but others want to do a 1031 Exchange, what can they do?
Many investors believe a solution does not exist and often agree to cash out. Those who want to complete a 1031 Exchange are then left paying capital gains, income, and depreciation recapture taxes. Thankfully, though, there is an alternative to this situation. The LLC may participate in either a drop and swap or partnership installment note transaction, depending on where they are in the sales process. Those in preparation mode can consider the drop and swap, while those in the last stage of their sale may qualify for the partnership installment note transaction.
In a previous article titled “Parting Ways: How to Do a 1031 Exchange When Breaking Up a Partnership,” we outlined the steps of a 1031 Exchange and a traditional drop and swap. Here’s a snapshot.
The drop-and-swap strategy allows investors to drop their current ownership structure – the LLC – and swap for a tenancy in common (TIC) interest. When a property is held in a TIC, the proceeds from the sale of the real estate are distributed to individual members, which allows them to choose whether to cash out or do a 1031 Exchange.
Generally, a drop and swap should be done prior to the sale of any real estate. Since a 1031 exchange is restricted for those who held their real estate for investment purposes, a drop and swap done too closely to the sale of the real estate could disqualify them for an exchange and result in a taxable event.
If an LLC is already in escrow for a property, and members have different opinions on what to do after the sale, they can consider a partnership installment note transaction. This allows some members to cash out while others can trade via an exchange. Here’s a breakdown of the steps involved in a partnership installment note transaction.
Please note, Perch Wealth does not provide legal advice, and individuals should consult with the appropriate professionals about all scenarios.
1- Before the LLC closes on the real estate, the LLC enters into a part exchange-part installment sale agreement with an exchange accommodator. The part exchange allows the LLC to complete a 1031 Exchange, while the part installment sale allows those who wish to cash out to be paid directly. An installment sale is a disposition of property where the seller receives at least one payment after the tax year in which the disposition occurs.
2- In this scenario, the accommodator holds a portion of the proceeds, which can be used to acquire the replacement property. The accommodator also issues an installment promissory note based on the balance of the proceeds of the sale and reflects the interest of the members who wish to cash out. While the delivery of the installment promissory note is “boot,” the gain is not recognized until payment is received.
3- To qualify as an installment sale, the payment of the note must be paid over a period of two or more tax periods. Therefore, the installment promissory note is delivered to the LLC just before its close date; then, typically, the note will call for payment of 90 to 95 percent of the principal shortly after the close, with the remaining percentage to be delivered the following year (typically January 2).
4- The LLC then distributes the note to the members who elected to cash out before the initial payment. When these members receive their distributions, they are taxed as if the sale of the real estate occurred. The LLC, on the other hand, defers taxes per the guidelines of a 1031 Exchange.
Investors should, however, consider a few issues before completing this type of sale.
First, those cashing out need to consider the impact of depreciation recapture. Generally, the installment sale payments are treated as recapture of depreciation, which is taxed at 25 percent at the federal level –all proceeds are calculated, not just the percentage of ownership of those cashing out.
Second, the debt must still be replaced in the exchange – 100 percent of debt at the time of sale; this means that those engaging in a 1031 Exchange must assume the debt percentage of those cashing out.
Third, if the property sale price exceeds $150,000, “IRC 453A requires a seller to pay interest on the deferred tax liability that results when it reports a gain under the installment method of accounting provided in IRC 453.” Interest is imposed if the obligation is outstanding as of the close of the taxable year and the face amount of all installment obligations held by the taxpayer that are outstanding at the close of the taxable year exceed $5,000,000. For LLCs and other partnership structures, the $5,000,000 threshold is applied, and the interest is calculated at the partner level.
Those considering selling real estate that is held in a partnership structure are advised to prepare for the sale. Speak with the appropriate representatives, including a certified public accountant (CPA) and accommodator, to plan for the sale. Via preparation, investors can reduce their risk of triggering a taxable event at the time of the sale, which could carry a heavy financial burden.
If you would like to learn more about a 1031 Exchange, and how you can benefit from an exchange, contact the team at Perch Wealth. Perch Wealth is an investment firm specializing in real estate and alternative investments, offering an unparalleled opportunity for select investors to build diversification into their portfolios
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