LLCs, partnerships and disregarded entities

The same-taxpayer requirement

Every question about entities in a 1031 exchange traces back to one requirement: the taxpayer that sells the relinquished property must be the same taxpayer that buys the replacement property. The tax return that reports the sale has to be the return that reports the purchase. An exchanger cannot sell as an individual and buy through a newly formed entity, and cannot sell through one entity and take title individually, unless the entity is disregarded for federal tax purposes in the way described below.

Single-member LLCs and other disregarded entities

A single-member LLC is disregarded for federal income tax purposes under the check-the-box regulations at Treas. Reg. §301.7701-3: the LLC files no separate income tax return, and its activity is reported directly on the owner's return. A grantor trust and a qualified subchapter S subsidiary work the same way. Because the tax law looks through the entity to the owner, the owner is the taxpayer for exchange purposes, not the LLC or the trust. An owner can sell relinquished property through one disregarded entity and buy replacement property through a different disregarded entity, or in the owner's own name, as long as the underlying owner is the same on both sides. What has to stay consistent is the identity of that owner across the closing documents, not the name on the deed.

Husband-and-wife LLCs in community property states

An LLC owned entirely by a married couple as community property, in a state that recognizes community property, may also be treated as disregarded rather than as a partnership, under Rev. Proc. 2002-69. Where that treatment applies, the couple is treated the same as a single owner for exchange purposes. Whether a particular LLC qualifies depends on the state's community property rules and how the couple elected to be treated, which is a question for the couple's tax advisor before any sale is listed.

Multi-member LLCs are partnerships

A multi-member LLC is, by default, taxed as a partnership and files its own return on Form 1065. Unlike a disregarded entity, a partnership is a separate taxpayer. The partnership owns the real property; the individual members own an interest in the partnership, not a deed to the property. For exchange purposes, that distinction controls everything that follows.

Partnership interests are excluded from section 1031

Section 1031(a)(1), as amended for exchanges after 2017, limits the like-kind exchange rule to real property, and the regulations exclude partnership interests (except where a valid section 761(a) election is in effect). An individual member cannot exchange a membership interest for replacement real estate. While the partnership owns the property, only the partnership can exchange it, as the taxpayer, selling and buying the replacement property in the partnership's own name.

When partners want different outcomes

Where every partner is content to stay together and reinvest as a group, the partnership does a single exchange into one replacement property, and the entity mechanics are no different from an exchange by any other taxpayer. The harder case is when the partners want to go separate ways: one wants to defer, one wants to cash out, one wants a different property entirely. The partnership can complete only one exchange as one taxpayer, so individual members cannot each run their own 1031 exchange on a share of property the partnership still owns.

One common path is for the partnership to complete its own exchange and later distribute interests in the replacement property to the members who want out. Another is the "drop and swap": before the sale, the partnership distributes the property to its members as tenants-in-common interests, so each member directly holds an undivided share of the real estate rather than a partnership interest. Once that conversion has happened, each co-owner is free to exchange their own share, sell it and pay tax, or hold it, independently of the others. Because 1031 treatment depends on the property being held for investment, a drop that happens immediately before the sale invites scrutiny over whether the members genuinely held their tenancy-in-common interest for investment purposes, rather than for an instant on the way to a sale that was already arranged; the facts and the timing around the drop matter. The reverse sequence, a "swap and drop," has the partnership complete the exchange first and distribute interests in the replacement property to the members afterward, which carries a similar timing concern in the other direction.

The section 761(a) election and tenancy-in-common structures

Co-owners who hold property together but do not want to be treated as a partnership for tax purposes may, in qualifying circumstances, elect out of partnership treatment under section 761(a), which allows each co-owner to be treated as owning an individual interest in the underlying property rather than an interest in a partnership. Separately, Rev. Proc. 2002-22 sets out the conditions the IRS looks to when co-owners want to hold replacement property together as tenants-in-common rather than through an entity, which is one way unrelated investors combine to acquire a single replacement property while each remains a separate taxpayer.

Related-party rules

When a taxpayer exchanges property directly with a related person (under sections 267(b) or 707(b)(1)), such as a family member or a commonly controlled entity, section 1031(f) generally undoes the deferral if either party disposes of its property within two years, with exceptions for death, involuntary conversion and transactions without a tax-avoidance purpose. Buying replacement property from a related party through a qualified intermediary generally does not qualify at all if the related party receives cash (Rev. Rul. 2002-83). This guide only flags the rule; a related-party exchange needs its own review before it is structured.

Documentation

Whatever the structure, title, the deed, the exchange agreement and the W-9 given to the qualified intermediary all need to describe the same taxpayer consistently. Where title is held by a disregarded entity but the taxpayer for exchange purposes is the underlying owner, the exchange agreement should identify both: the entity that holds title, and the taxpayer that the exchange is being done for. Mismatches between these documents are a common, avoidable reason a straightforward exchange runs into questions at closing. See the exchange checklist for what to have ready before a sale is listed, and what a 1031 exchange is for how the rest of the transaction works.

Sources

• Internal Revenue Code §1031(a)(1), (e) and (f); Treas. Reg. §1.1031(a)-3(a)(5).
• Treas. Reg. §301.7701-3 (entity classification; disregarded entities).
• Rev. Proc. 2002-69 (qualified entity owned by a married couple in a community property state).
• IRC §761(a) (election to be excluded from partnership rules).
• Rev. Proc. 2002-22 (tenancy-in-common co-ownership arrangements).
• IRS Form 8824 and instructions.