Many real estate investors combine 1031 exchanges with other estate planning tools to reduce taxes, but there are several other reasons you might consider exploring these options. Establishing a trust or limited liability corporation with a 1031 exchange can offer additional asset protection, centralized management, and potential valuation discounts for estate tax purposes.
- 1031 exchanges allow real estate investors to trade one property for another while deferring capital gains taxes.
- Combining a 1031 exchange with an LLC or trust can provide additional benefits, including personal asset protection and reduced liabilities.
- It can also prevent a property from going to probate before the beneficiary receives it, which saves time and court fees.
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What Are 1031 Exchanges, LLCs, and Trusts?
Understanding how 1031 exchanges, LLCs, and trusts work can help you identify the smartest ways to combine them. Here’s a brief overview of each of these terms:
Savvy real estate investors often use 1031 exchanges to defer taxes and build wealth. The idea behind a 1031 exchange is simple: by trading one investment property for another, you can successfully defer capital gains taxes. However, it’s important to understand certain rules and portions from Section 1031 of the Internal Revenue Code. For example, the Internal Revenue Service only allows you to complete a 1031 exchange between like-kind properties and limits the use of this tactic when dealing with vacation properties.
To get the most out of a 1031 exchange, it’s helpful to have some background knowledge on LLCs and trusts, both of which you can use in conjunction with a 1031 exchange to maximize your tax-deferred investment growth, depending on your unique circumstances.
An LLC is a popular business structure that combines traits typically associated with corporations and sole proprietorships or partnerships. Like a corporation, when you establish an LLC for your business, you separate yourself as the owner from its liabilities and debts, so you are not personally responsible. And like a partnership, you can report taxes on your individual tax return using the flow-through taxation method.
Owners, also known as members, of an LLC may include individuals, corporations, foreign entities, or other LLCs. Each state chooses how to regulate LLCs, so there may be some differences between locations.
A trust is a legal arrangement that appoints a trustee to manage assets for a beneficiary. Real estate investors often establish trusts to reduce estate taxes, but they also serve to give beneficiaries access to assets faster than a traditional will, since trusts typically don’t move through probate.
When you establish a trust, you also determine who receives distributions, when they get them, and what contingencies you want to set in place, ensuring you have control over your wealth and your financial legacy to make things easier for your loved ones. Trusts are often separate from a person’s taxable estate, which means fewer taxes may be due when the owner passes away.
Benefits of Holding Properties in an LLC or Trust
While you can own real estate as a sole proprietor, moving your properties to an LLC or trust may provide you with additional asset protection and reduce risks. However, there are some key differences between these two options, and it’s important to be aware of them before you decide which one is right for you. Here are some advantages of holding real estate within an LLC or trust:
Holding property in an LLC provides investors with certain legal protections by keeping other personal and business assets separate from creditors if a lawsuit occurs. For example, if the real estate property you own is no longer viable, you can declare bankruptcy as an LLC without affecting your personal assets. While creating a real estate trust may offer some protection to your beneficiaries by ensuring they receive the property you designate and eliminating tax liabilities, it does not protect your other personal or business assets from creditors.
Ease of Management
As a business entity, LLCs are typically easier to establish and manage than a corporation. Since an LLC can have multiple members, it may also be ideal if you have several real estate investors who own a property together. This arrangement allows members to provide loans and equity capital directly to the LLC. Similarly, a real estate trust can include multiple owners. This allows you to document relationships and the interests of each owner to ensure their portion of the property moves to the correct beneficiaries.
Establishing a real estate trust makes it easier to pass property to a family member or heir by reducing taxes and avoiding probate. This is a common way to ensure property passes seamlessly from one generation to the next. While LLCs operate differently, they do provide members with the option to buy or sell the individual shares they own without having to sell the real estate property itself. This can make it easier to transfer portions of your real estate, depending on your LLC’s operating agreement.
Since income and losses pass through each member of an LLC, real estate investors who use this method file individual tax returns and avoid a second tax on corporate profits. This can reduce the overall amount of taxes you pay each year. Establishing a real estate trust can decrease the taxes your beneficiaries pay by eliminating estate taxes when the property moves to them. Properties held in a trust also remain separate from your personal assets, which can lower your individual tax liability.
How To Execute a 1031 Exchange With Properties Held in LLCs
Both single-member LLCs and partnership LLCs can conduct 1031 exchanges with properties held in LLCs, but there are some caveats. In a single-member LLC, the individual owner of the LLC is also the legal owner of any properties held within it. This means the owner of the LLC can sell the property through a 1031 exchange and require a replacement property without conducting a separate transaction outside of these parameters.
Conducting a 1031 exchange with a partnership LLC can be more challenging. However, if the entire partnership agrees to relinquish a property held within the LLC, they can complete a 1031 exchange at the entity level. After, the partnership can purchase another property as long as the partnership remains intact.
The Drop and Swap Strategy
Here’s how to execute a 1031 exchange with properties held in a partnership LLC using the drop and swap strategy:
- Under Section 709 of the IRC, dissolve the partnership.
- Allow new or existing partners to acquire the interests of any partners who wish to leave the partnership by cashing out and paying individual taxes.
- Have the partnership complete a 1031 exchange and refinance the acquired like-kind property.
- Distribute cash to the partners who do not want to participate in the 1031 exchange.
- Reorganize the partnership under co-tenancy ownership, where at least two owners maintain an undivided fractional interest in the property.
- Distribute the property based on each co-tenant’s pro-rata interest.
- Hold the new replacement property in the partnership for approximately 24 months to qualify for the 1031 exchange treatment.
- As the partnership, submit an election according to Section 761(a). This opts the partnership out of the Subchapter K application.
Using Trusts in Conjunction With 1031 Exchanges
There are two main types of trusts investors use in conjunction with 1031 exchanges: revocable and irrevocable trusts. While there are differences between them, their primary goal is to prevent a property from entering probate before being passed to the beneficiary. Certain trusts may also offer additional privacy for property holders. Here’s an overview of how each of these works:
In a revocable trust, the grantor or the creator of the trust can make amendments at any time. This individual typically also acts as the beneficiary and the trustee, which allows them to relinquish properties held within the trust and purchase replacement properties as a single-member LLC or an individual.
An irrevocable trust cannot be modified once it’s created. If you establish an irrevocable trust, you will receive a designated tax ID number to file your taxes separately. This makes the irrevocable trust the taxpayer, which means to complete a 1031 exchange, you will need to sell the relinquished property and purchase the replacement property within the same trust.
Potential Pitfalls and Legal Considerations
Before you complete a 1031 exchange with a trust or an LLC, there are some potential pitfalls and legal considerations to be aware of. Here are a few of the most common issues people run into:
- Depreciation recapture: If you conduct a 1031 exchange between an improved property with a building onsite and a property without a building that has not been improved, any depreciation you claimed on the previous property may be recaptured and considered ordinary income.
- Need for a qualified intermediary: Unless you are swapping one property for another like-kind property at the same time, you will need to hire a qualified intermediary to hold the cash you make from selling the first property and use it to purchase the replacement property.
- The 45-day rule: Within 45 days of selling the first property, you need to provide written notice of the new property you plan to purchase to the intermediary.
- The 180-day rule: Additionally, you need to close on the new property within 180 days of selling the original property.
If you’re considering combining a 1031 exchange with an LLC or a trust, we’re here to help. Schedule a consultation with Anderson Advisors today, and we’ll help you determine which option is best for you.
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