The initial issue when addressing exchanges involving Partnerships or LLC's (Limited Liability Companies) is whether the Partnership or LLC will complete an exchange as the same entity that started the exchange or whether one or more of the partners or LLC members will attempt an exchange of property for an interest in such an entity in the replacement property. As long as the Partnership or LLC meets all of the requirements of IRC §1031, that entity may do a tax deferred exchange; provided, of course, if the Partnership or LLC sells the relinquished property, the Partnership or LLC, and not its individual partners or members, must take title to the replacement property. The more commonly asked and challenging question is whether the individual partners or LLC members may go their separate ways, thereby exchanging out of a Partnership or LLC interest in the relinquished property or exchanging from their personally owned relinquished property into a Partnership or LLC interest in the replacement property. The fundamental problem is that an interest in a Partnership or LLC (or any number of exotic variations of these entities) is considered personal property and therefore not like kind to real estate interests. See IRC §1031(a)(D). One possible solution is to dissolve the Partnership, under IRC §708, and distribute the real estate asset to the former partners as co-owners with tenant-in-common interests. These direct ownership interests are of like kind to replacement real estate interests. Care must be taken that the Partnership is fully and effectively dissolved. If certain conditions are met, IRC §761 allows the partners to elect to not be subject to Partnership treatment. In the tenant-in-common situation, the individual Exchangers may elect to complete the exchange and then contribute the replacement property to the Partnership or to the LLC at a later date.

The next issue is whether the property owned by the dissolved Partnership and distributed to the tenant-in-common co-owners, has been held for income production or investment purposes as required by IRC §1031, prior to its sale to start the exchange or after its acquisition to end the exchange. While there are no recent cases directly on point, it is advisable to transfer ownership to the individual Exchangers as far in advance of the exchange as possible. See generally Magneson v. C.I.R., 753 F.2d 1490 (9th Cir. 1985) and Bolker v. C.I.R., 760 F.2d C.I.R. (1985) where the courts allowed tax-deferred exchange treatment based on the holding that contribution to or from a Partnership is an allowable change in the form of ownership rather than a disposition that would disqualify the property from exchange treatment. Also, see Chase v. C.I.R., 92 T.C. 53 (1989), which is instructive on the elements to avoid when attempting to dissolve a Partnership prior to an exchange, such as the Exc hanger's failure to negotiate on behalf of themselves, their failure to pay their respective portion of the broker's fees, and the fact that in apportioning the net sales proceeds, the Exchanger's were treated as partners, rather than as direct owners.

LLC Issues

Alternate forms of ownership on the purchase side of a tax deferred exchange that are required when a lender wishes to shield its security interest in the replacement property in a bankrupt remote entity, are now generally less problematic than the above Partnership scenario. The most common form of ownership in a new entity is the single member limited liability company. In addition to a single member LLC, there are other, so called "pass-through" entities which are disregarded by the IRS as a entity separate from the taxpayer, such as a Delaware business trust, a Massachusetts nominee trust, an Illinois land trust, and grantor trusts. Other examples, such as subsidiaries of corporations, or new corporations formed by mergers or acquisitions of other corporations, can also provide for different parties on each side of an exchange.

In the case of single member limited liability companies, the initial question has always been whether taking title in the name of the new LLC would be characterized as a Partnership or beneficial interest, therefore falling under one of the exclusions enumerated in IRC §1031(a)(2). One exception to the general rule that the same taxpayer entity that sells the relinquished property has to purchase the replacement property is found in Treas. Regs. §301.7701-(3)(b)(1) which allows "single-member LLC's" that acquire property to be ignored for tax purposes and to be treated as the direct owners of the property. Not all states allow single-member LLC's so the taxpayer should consult with legal counsel to determine if the taxpayer's state will allow the use of a single member LLC. The use of single member LLC's allow an individual or entity to sell property to start an exchange and complete the exchange by purchasing in the name of the LLC.

In general, an entity with only one owner will be classified either as a disregarded entity, or a corporation, whereas an entity with two or more members will be classified as a Partnership or a corporation. Accordingly, an entity with only one member, which does not elect to be treated as a corporation will be treated as a disregarded entity. This allows a taxpayer to take title in a new entity, fulfilling a lender’s requirement, without jeopardizing the viability of the exchange. Treas. Reg. §301.7701-2(c). A classification change can be accomplished by an eligible entity by filing Form 8832 - Entity Classification Election. Treas. Reg. §301.7701-3(c)(1)(i). A classification change can be effective up to 75 days prior to, or 12 months after the date upon which the election is filed. However, the entity may not make any more classification elections within 60 months after the effective date of the classification. Treas. Reg. §301.7701-3(c)(iv). In a recent Private Letter Rul ing, the IRS approved of a special purpose bankruptcy remote entity to be formed as an LLC with the taxpayer and the taxpayer’s wholly-owned corporation, with the replacement property lender’s representative on the board of directors, to be the members of the LLC for purposes of owning the taxpayer’s replacement property in the taxpayer’s exchange.

As LLC’s become increasingly popular as a means for investors to own real estate the same questions arise for LLC’s and their members as with Partnerships. There is little authority regarding LLC’s and exchanges, but most tax analysts agree that assuming the LLC is treated as an association, the same principles apply. If the LLC were going to do an exchange, it would be prudent for the same members to sign the Replacement Property Identification Notice as would be necessary to bind the LLC in any other matter. See Example 5 in Treas. Reg. § 1.1031(k)-1(j)(3) shows that liabilities on the Relinquished Property may be netted against liabilities on the Replacement Property. Therefore, it seems likely that the “liability gap” issues under IRC §752 will not cause recognized gain for LLC members, or Partnership partners, because of an exchange. The “at risk” rules of IRC §465 may apply to the LLC’s members’, or partners’, detriment if the Replacement Property is not considered an “aggr egation” of the Relinquished Property.