A single-member limited liability company (LLC) may be a desirable form of ownership for both real property and tenants-in-common interests. In most cases, an LLC will limit an investor’s exposure to creditors and litigants to the equity in the property and thereby shield personal assets. Consequently, lenders will often insist on a loan covenant requiring that property be held in a limited liability entity.
An LLC is a pass-through entity for federal and state income tax purposes with no tax at the entity level and net income passing through the entity to the owner’s tax return (Schedule E for individuals). The single-member LLC is not disqualified as one of the enumerated exclusions in IRC §1031(a)(2), as is a partnership because the single-member LLC is disregarded by the IRS as an entity separate from the taxpayer. Other pass-through entities which are disregarded by the IRS are a Massachusetts nominee trust, a Delaware business trust, an Illinois land trust, and a grantor trust. Please note that not all states allow single-member LLCs.
The LLC (or disregarded entity) is one of the few exceptions to the rule that the taxpayer entity that sells the relinquished property must be the same entity to purchase the replacement property. The exception, found in Treasury Reg. §301.7701-(3)(b)(1), allows the single-member LLC that takes title to the property to be ignored for tax purposes and treats the individual or entity owning the LLC as the direct owner. Furthermore, in Letter Ruling 200131014, a taxpayer acquired title to the replacement property and then deeded the property over to a single-member LLC in which the taxpayer was the sole member.
An entity may elect a classification change by filing Form 8832 under the “check the box” rules. Accordingly, an entity with only one owner may elect to be treated as either a disregarded entity or as a corporation, and an entity with two or more owners may be classified either as a partnership or as a corporation. If no election is made, the single-member entity will automatically be treated as a disregarded entity. Thus, a taxpayer may take title to the replacement property in the form of an LLC to satisfy loan requirements and not be in danger of the exchange being disqualified for Section 1031 treatment. A classification election may be effective up to 75 days prior to, or 12 months after the date the election is filed. An additional election may not be made within 60 months of the effective date of the previous election.
A two-member LLC was permitted to receive title replacement property and enjoy a tax-deferred exchange when the taxpayer and the taxpayer’s wholly-owned corporation were the two members of the LLC. In this case, the lender was a board member of the corporation in order to protect the lender’s interest by preventing the corporation from ever filing for bankruptcy. The IRS disregarded the two-member LLC similar to a single-member entity and noted that the corporation did not have rights or risks regarding profits, losses, or management of the LLC.