Wednesday, 20 September 2017

Using 'Disregarded Entities'

Written by Posted On Tuesday, 11 April 2006 00:00

In a recent article I wrote for Realty Times entitled, "Title Holding Issues in 1031 Exchanges ," I set out the requirements for holding title to your property in a 1031 exchange. That article pointed out some of the obvious problems caused by these rules. In this article I will show you some solutions, or ways around those problems, using disregarded entities.

The basic rule for holding title to property in a 1031 exchange is that how you hold title to your old property is how you have to take title to your new property. What this means is that title to the new property has to be taken by the same tax return that held title to the old property. For example, if Sue owned her old property in her individual name, she could not have her corporation take title to her new property because the tax return (Sue's) that owned the old property is different from the tax return (the corporation's) that would take title to her new property and the exchange will fail.

There are four exceptions to the title holding rule (actually, as you will see, they are not exceptions, but simply variations), and these involve the use of what the IRS calls "disregarded entities." A disregarded entity is an entity that holds legal title to property, but is not required to file an income tax return. There are four types of disregarded entities: revocable living trusts, Illinois type land trusts, single member limited liability companies and Delaware Statutory Trusts.

A revocable living trust is an estate planning device designed to avoid probate. These types of trusts hold title to property but don't file tax returns. This means that if Sue owns her old property in the Sue Jones Revocable Living Trust, the trust is in title to the old property, but Sue's individual income tax return has (IRS Form 1040) actually owned the property. Therefore, Sue can take title to the new property in her own name rather than having to take title in the name of the Revocable Living Trust because it was her personal tax return that owned both the old and new property.

An Illinois type land trust (you find these in states other than Illinois, as well) is a title holding vehicle designed to hide the actual owners of the property from public view. If an Illinois type land trust holds title to a $300,000 building as the "FGH Land Trust" and Fred, George and Howie are equal owners (called beneficiaries) of the land trust, Fred, George and Howie are treated as the true owners of the property by the IRS. FGH Land Trust does not file an income tax return and each of the three owners report their one-third share of the income and expenses on their individual income tax returns. Fred could sell his share to Ivan for $100,000 in a 1031 exchange and buy a replacement property and take title in his own name: his individual income tax return owned his one-third share of the old property and his individual income tax return owns the replacement property. The problem with this type of land trust is that it provides no limit to the liability of Fred, George and Howie and they can each be sued individually or as a group in connection with the property.

Limited Liability Companies (or LLC's) file partnership tax returns. Since there is no such thing as a single partner partnership, if an LLC with only one member tried to file a tax return, the IRS would return the tax return with instructions to report all of the income in the sole shareholders personal tax return instead. This means that if Fred holds title to his old property in a single member LLC called Fred's Investments, LLC, he can sell that property and do an exchange and take title to his new property in his own name because his individual tax return owned both properties. The benefit of LLC's is that they protect you from liability, but if Fred, George and Howie want to go together to buy a property and be able to do separate exchanges, they will each need to form a single member LLC to hold their interest. This becomes cumbersome and the lender may not want these different parties on title to the property.

The final type of disregarded entity is called a Delaware Statutory Trust (or "DST"). DST's combine the best of Illinois type land trusts and single member LLC's. You take title to the property in the name of the DST, but each member (also called beneficiaries) of the DST is treated as the owner of their share of the property, and like LLC's the DST protects the individual owners from liability without the hassle of setting up, and taking title to the property, using multiple LLC's. DST's are relatively new and have some other limitations, but they can be the real solution to sticky ownership issues.

The last thing I want to point out is that it is possible, and common, to chain together a series of disregarded entities. A building that is owned by a single member LLC, with the Sue Jones Revocable Living Trust as the sole member, is for IRS and 1031 exchange purposes, owned by Sue Jones herself.

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