Use of Disregarded Entities in Like-Kind Exchanges

After successfully raising capital and providing investors with a return on that capital, real estate fund sponsors are rightly concerned with delivering an acceptable means to exit the investment. A successful fund will hold appreciated property, so an exit often means selling the property and distributing the net proceeds. Inevitably, the sponsor and certain select investors will want to defer tax on the sale and roll their equity to another property or properties, if possible.  

In these situations, some sponsors have attempted to accommodate the investors by altering the existing ownership of the relinquished property in a way that allows for disparate treatment among the investor group – some electing to receive their share of the sale proceeds, while others electing to roll their equity into a new investment.  

Although the transition to a new form of ownership carries risk, with some work, it can be accomplished. It is not uncommon to see entities that are disregarded for income tax purposes in making the transition. Here, we review how some taxpayers have used disregarded entities in exchange transactions and contemplate a potential means to satisfy those investors looking to roll their equity. 

Expanded Use of Disregarded Entities 

The scope in which taxpayers have successfully used disregarded entities in accommodating like-kind exchanges has broadened. Consider the progression in thought among the following Private Letter Rulings (PLRs) issued by the IRS,  

• PLR 9807013: the taxpayer’s receipt of replacement properties by separate single-owner non-corporate entities formed to take title to each replacement property was treated as the receipt of real property directly by the taxpayer for purposes of qualifying the transaction as a tax-free like-kind exchange.  

• PLR 200131014: the taxpayer’s post-exchange transfer of replacement property to a wholly owned disregarded LLC did not violate the holding requirement. The transfer was disregarded, and the taxpayer was still considered the direct owner of the property.  

• PLR 200118023: the taxpayer’s receipt of the entire ownership interest in an LLC that owned real property and whose owner was acting as an exchange accommodator (qualified intermediary, or QI) was treated as the receipt of replacement property directly by the taxpayer for purposes of qualifying the receipt of such property as for nonrecognition under section 1031. The IRS also noted that nonrecognition only applied to the LLC's like-kind property held for use in trade or business or for investment – the LLC's non-like-kind property was taxable as boot. 

In each of these instances, the facilitating entity was disregarded as an entity separate from its owner for federal income tax purposes, such that receipt of an ownership interest in the LLC was treated as receipt of real property by the taxpayer-owner.  

PLR 200807005 

In PLR 200807005, the IRS concluded that a taxpayer’s receipt of all the interests of the partners in a partnership that held real property, in part by a disregarded entity created by the taxpayer, was treated as the receipt of the real property assets of the partnership that is like-kind to the taxpayer’s relinquished property, provided all other Section 1031 requirements were met. Although clearly done in coordination with the QI, it is interesting that the taxpayer appears to have acquired the interest in the partnership that owned the replacement property directly from the partners and not from the intermediary, as was the case in PLR 200118023.  

Role of Revenue Ruling 99-6 in Interpretation 

In reaching the conclusions in PLR 200807005, the IRS considered the analysis and holdings in Situation 2 of Revenue Ruling 99-6, where equal partners in an LLC taxed as a partnership sold their entire interest to an unrelated person in exchange for cash.  

The revenue ruling held that the partnership terminated upon purchase of the interests and that, for purposes of classifying the acquisition by the unrelated buyer, the partnership was deemed to have made a liquidating distribution of assets to the former partners, immediately after which the buyer was deemed to have purchased the former partnership’s assets. This is despite the asymmetric treatment for the selling partner. That is, although the revenue ruling treated the buyer as having acquired the assets of the former partnership, it characterized the seller as having sold their partnership interest. 

Generally Favorable Outcomes & Continued Relevance  

The facts of these rulings and their generally favorable outcomes illustrate how taxpayers have become more creative in utilizing disregarded entities to either accept receipt of replacement property or transfer replacement property post-exchange.  

Although the rulings were issued before the latest restrictions on what is considered eligible property for Section 1031 exchanges, regulations clarified that what previously qualified as real property still qualifies as real property. Thus, the analyses relied upon in previous rulings are still relevant and may help guide the exit from an investment with varying interests among the ownership group.  

Hypothetical Example 

For example, assume that relinquished property is owned by Partnership AB and replacement property owned by Partnership AC.  The same sponsor, A, is participating in both investments. Partnership AB conveys the relinquished property and any rights to acquire the property by an unrelated buyer to an intermediary. The intermediary will help to execute the sale of the relinquished property and take custody of the sale proceeds in pursuit of a like-kind exchange. 

The sponsor receives an interest in Partnership AB in exchange for the rollover interest in Partnership AC, while the intermediary and partners of Partnership AC coordinate the purchase of outstanding interests in Partnership AC using the exchange proceeds to fund the buyout. The selling partners transfer their interests in Partnership AC to Partnership AB à la PLR 200807005 such that immediately following the transfers; the former Partnership AC is wholly owned by and disregarded as an entity separate from Partnership AB.  

Challenges and Considerations 

This example illustrates a complicated transaction with several potential traps. The value of the new interest in Partnership AB received by the sponsor would correlate to the sponsor’s former interest in Partnership AC, deemed to have been received to avoid a taxable transfer of value. This also creates accounting complexities for the post-exchange partnership. To avoid boot, the exchanging partners would need to avoid debt relief. Additionally, the exchange would need to pass muster under the related party rules. The identification, closing window, and other Section 1031 exchange requirements must also be met. 

Application of PLR 200807005 

It is not without total certainty, but assuming all of this to be the case, one possible interpretation might be that:

1. The interest acquired from the selling partners in former Partnership AC be treated as a fractional interest in the real property owned by Partnership AC and received as qualifying replacement property in Partnership AB’s like-kind exchange and
2. The interest acquired from the exchanging partners in former Partnership AC be treated as the contribution of a fractional interest in the real property owned by Partnership AC under Section 721.  

The results of this interpretation appear to be that, 

• The sponsor would have deferred gain on the rollover interest,  

• Partnership AB would have successfully deferred gain from selling the relinquished property and  

• The selling partners in Partnership AC would have received their due share of proceeds from selling the replacement property.  

Effectively, the sponsor would have used equity in Partnership AB to buy out the exiting investors’ interests in Partnership AC. 

The Future of Disregarded Entities in Like-Kind Exchanges 

The use of disregarded entities by creative taxpayers to facilitate the desires of investors in the marketplace is likely to evolve further. Although private letter rulings cannot be used or cited as precedent, they can provide insight into how the IRS might view contemplative transactions where more formal guidance is lacking. 

It is advisable to consult your tax advisor whenever engaging in a transaction or series of transactions. If you have specific questions related to like-kind exchanges or the use of disregarded entities to facilitate transactions, contact our team using the form below.