1031 Exchanges for Property Owned by Partners or an LLC

Many New York rental buildings are owned by several people together: friends who formed an LLC to buy a building, or siblings who inherited their parents’ house. When it is time to sell, a common situation arises: some owners want a 1031 exchange to keep investing, and others want to cash out. How does a 1031 work then?

First: Who Is the “Taxpayer”?

The “same taxpayer” rule is especially important with multiple owners:

Partnership interests and LLC membership interests themselves cannot be exchanged (Section 1031 expressly excludes them). In other words, you cannot “exchange” your share of an LLC for a new property.

A New York Trap: The Spouses’ LLC

In community property states such as California, an LLC owned by two spouses can elect to be treated as a single taxpayer. New York is not a community property state, so an LLC formed by two spouses is generally treated as a partnership, a separate taxpayer.

So if property was titled in the spouses’ individual names and, after the sale, the couple buys the replacement through a newly formed LLC, the “same taxpayer” rule may be violated. Either buy in the same names, or have your attorney design the structure in advance.

Some Want to Exchange, Some Want Cash: What Now?

Option one: the LLC exchanges as a whole, and adjustments come later

The LLC sells and buys as a whole, and all members stay in the LLC. Members who want out make other arrangements later. The drawback is that those who want cash must wait.

Option two: the LLC takes some cash

The LLC does a partial exchange, and the cash taken (boot) is taxable. But that tax is shared by all members in proportion, including those who want to keep investing, so the operating agreement usually needs a separate arrangement.

Option three: “drop and swap”

Before the sale, the LLC distributes the property to the members in proportion to their interests, so each holds a direct tenancy-in-common share. At the sale, members who want a 1031 exchange do their own, and members who want cash pay their own tax.

This approach is widely used, but the risk is that the IRS may argue that members who received their shares and sold right away did not “hold for investment.” The longer the gap between distribution and sale, and the more the co-owners act like genuine co-investors (for example, a co-ownership agreement, shared management and each bearing their share of income and expenses), the stronger the position.

Option four: “swap and drop”

The LLC completes the exchange first and later distributes the replacement property to the members. The same “holding intent” risk applies, and timing matters.

New York Transfer Tax Issues

When an LLC distributes property to its members (deeding it from the LLC to the members), New York transfer tax may apply. If it is a mere change in the form of ownership with no change in the owners’ proportionate interests, New York State and City exemptions may apply, but the conditions must be reviewed carefully. Also, transferring 50% or more of the interests in an LLC can be treated in New York as a transfer of the real property and trigger transfer tax.

Inherited Property: Good News

Siblings who inherit a parent’s house usually hold it as tenants in common, not through an LLC. That means:

• Each sibling can decide separately whether to exchange or take cash;
• The basis was already stepped up to the value at the parent’s death, so if the house is sold soon after inheritance, the gain may be small and a 1031 may not be necessary.

Limits on Related-Party Transactions

1031 transactions with related parties, such as relatives or companies you control, face special limits. For example, buying replacement property from a related party is usually not allowed, and when related parties exchange with each other, both generally must hold their properties for two years. Transactions involving family members must be analyzed in advance.

Attorney’s Insight

With co-owned property, the hardest part of a 1031 is often not the tax law but the people. Each owner’s age, finances and plans differ. Our advice:

• Start the conversation a year or two before selling. If someone is likely to want out, a drop and swap needs time to set up. Distributing the property just before signing a sale contract carries the most risk;
• Read the LLC operating agreement first. Whether members can exit, how interests are valued and who decides on a sale and exchange are often already addressed there, and may need amending;
• For new purchases, think about how you would “split up” later. If partners may eventually go separate ways, holding title as tenants in common from the start, with a thorough co-ownership agreement, may offer more flexibility than a multi-member LLC. But tenancy in common offers weaker liability protection, and the tradeoff should be weighed.

Attorney’s perspective

With property held by partners or an LLC, the owners often want different things. We review the operating agreement, assess how ownership could be restructured before or after the exchange, and handle the negotiations among the owners.

For advice about your own situation, call +1 718-218-5805 or schedule a consultation. We meet clients in Flushing and Manhattan, in English or Chinese.

Series overview

This article is for general information only and is not legal advice. Reading it does not create an attorney-client relationship. For advice about your situation, please contact us.

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