Q: Does doing a 1031 exchange inside an LLC come with any additional headaches?

A: A 1031 exchange is term used to describe the sale and purchase of real estate that defers the payment of any federal income taxes. If you own investment real estate, the federal government allows you to sell that property and defer paying any federal income taxes on the profits of the sale if you buy a replacement property within a certain period of time.

If you purchased an investment property some time ago and have decided to sell it, you may have a huge profit on the sale and you might have also benefited by depreciating the investment on your income tax returns for the many years you owned it. If you have decided to sell this property, you might have a huge tax bill to pay. And, if you don’t want to pay that tax bill at the time of the sale, you’d go to a tax deferred exchange company to set up a 1031 exchange.

Once you sell and have set up the 1031 exchange, you’d have 45 days to identify a new like-kind property to purchase and you’d have up to 180 days to actually purchase that replacement investment property. The rules are rather technical, but you can exchange any type of investment real estate for other investment real estate.

One interesting thing about 1031 exchanges is that they can be used for property other than real estate. If you own an airplane for investment purposes, you can sell that one and buy another one using a 1031 exchange to defer the payment of any federal taxes on the sale of the airplane.

Now, while there are no added difficulties to completing a 1031 Exchange within an limited liability company (LLC), you might encounter complications in using an LLC especially if the LLC is being taxed as a joint partnership.

When people set up LLC they have a choice to be taxed as a partnership or as a corporation. Frequently, the preferred method of owning real estate in an LLC is to elect to be treated as a partnership.

But when the LLC decides to sell the real estate they own, some of the members sometimes decide they’d rather cash out and pay taxes on whatever they have made.

If the partners decide they do not want to remain as such because they want to go their separate ways, the sale of the real estate and how it’s taxed becomes a problem for the LLC.

Before considering a 1031 exchange within an LLC that is taxed as a partnership, make sure all the partners are on the same page. If the partners do disagree on whether or not to do an exchange, there are structuring alternatives that may be implemented. Ricky Novak, CEO of Strategic 1031 Exchange Advisors, outlines two alternatives that LLC members can use when selling a property owned by the LLC: the “drop and swap” and its counterpart, the “swap and drop.”

Novak explains that a “drop and swap” transaction occurs when certain LLC members are paid off and leave the LLC (‘dropped’) prior to the sale of the property the LLC owns and is selling. These dropped out members become tenants in common with the LLC or other partners prior to the sale and when the property is sold, the former members of the LLC and the LLC can each decide how to move on when the property is sold.

Some of them can decide to cash out and pay taxes on the money they get while others could set up their individual 1031 exchanges on the sale of the LLC property but each can then decide to go in separate paths in buying new properties.

The risk here is the members of the LLC and the LLC are not the same taxpayer and therefore the members of the LLC, if performing an exchange, need to re-establish a qualified use of the property prior to the sale (i.e. the property was held for investment or used within a trade or business by the individual taxpayer). If this transaction is not planned out well in advance the members may have trouble proving to the IRS that they owned the property for investment purposes, so be sure to plan accordingly if you decide to go this route.

The second strategy is the “swap and drop.” According to Novak, instead of individual members performing the 1031 exchange, the members sell the property they currently own (the ‘swap’). And, upon acquiring a replacement property, each member of the LLC dictates that the LLC must identify a property he or she wishes to acquire. The LLC then uses new single-member LLCs to acquire each of those replacement properties for each of the LLC members.

Novak recommends the LLC and even any new LLC continue to own the replacement properties for at least one year. After the one year time period has expired, each LLC can liquidate and distribute the money from the sales to the members of the LLC as had been agreed

These can be complicated topics for novice real estate investors and you should consider having a good team working with you including a 1031 exchange company, an experienced accountant or enrolled agent and an excellent real estate attorney.