Don't Disregard the Opportunity to use a Single Member LLC in a Tax Free Exchange

Single member LLCs provide numerous benefits for taxpayers exchanging investment property under Section 1031 of the Internal Revenue Code ("IRC"). For tax purposes, absent an election to the contrary, a single member LLC is "disregarded" as an entity separate from its owner. For Federal and State tax purposes, a disregarded entity reports its activities in the same manner as a sole proprietorship, branch or division of the owner.

Disregarded Entities and IRC § 1031 Exchanges.

1. Creditor Protection

Individuals (and individual beneficiaries of nominee trusts) can obtain creditor protection by transferring their investment real estate into a single member LLC at any point before or after an exchange. The IRS has privately ruled that a transfer of replacement property directly to a single member LLC owned by the taxpayer did not disqualify the transaction from IRC §1031 even though title to the relinquished property was held in the name of the individual Taxpayer.

2. Financing

Many lenders are reluctant to lend to other than single purpose and bankruptcy remote entities. A taxpayer seeking financing for replacement property can take title in a newly formed single member LLC owned by the taxpayer, and can even give the lender certain veto rights over major decisions.

In Ltr. Rul. 199911033, the lender financing acquisition of the replacement property insisted that title to the property be taken in a bankruptcy remote entity with two members – one of which was a corporation entitled solely to certain veto rights, and with no other economic or control rights. IRS ruled that the corporation was not a true “member” of the LLC, and that the LLC had only a single owner - namely, the exchanging taxpayer.

3. Avoid Real Estate Transfer Taxes

In Ltr. Rul. 2000118023 the taxpayer sought to avoid paying real estate transfer fees by accepting an assignment of 100% of the membership interests of a single member LLC in which the replacement property was parked. Since the LLC was a disregarded entity, the IRS reasoned that the receipt of the membership interests would be the same as receiving the real estate, thereby qualifying under § 1031. Query whether this strategy works under state law (see e.g. Massachusetts DOR Directive 95-5 dealing with deeds excise and nominee trusts).

4. Reverse safe harbor exchanges under Rev. Proc. 2000-37.

In Rev. Proc. 2000-37 the Service provided a safe harbor procedure for the qualification of certain arrangements between taxpayers and exchange accommodation titleholders ("EATs") for purposes of effectuating a reverse exchange. One of the requirements for qualification under the safe harbor procedure is that the EAT must have "qualified indicia of ownership" in the property. The Rev. Proc. provides that "interests in an entity that is disregarded as an entity separate from its owner for federal income tax purposes and that hold either legal title to the property or such other indicia of ownership" would be treated as "qualified indicia of ownership." Accordingly, single member LLCs can be used to effect safe harbor parking transactions.