The world of real estate can seem complex and daunting. One of the key areas of confusion often revolves around Section 1031 of the United States Internal Revenue Code. Used primarily in real estate transactions, Section 1031 allows for the deferral of taxes on the exchange of like-kind properties. But it’s not always as straightforward as it may seem—another element that largely influences this process is the ownership structure. From single-owner setups to multifaceted corporate structures, understanding these variances, why they matter, and determining the right choice for you can be the difference between a smooth real estate exchange and a tax nightmare. This article provides a comprehensive insight into the importance of different ownership structures.
Why Does Your 1031 Exchange Real Estate Ownership Structure Matter?
The ownership structure you choose for your 1031 exchange can have significant tax and legal implications. The main reasons why ownership structure matters include:
- Meeting the “like-kind” requirement – The properties must be of “like-kind” to qualify for tax deferment, which depends on how ownership is structured.
- Avoiding “constructive receipt” of funds – You must avoid having control or access to the exchange funds to prevent taxable events before completing the exchange.
- Limiting liability – Some structures limit personal liability more than others.
- Facilitating shared ownership – If you want to co-invest with others, the ownership structure affects how this can be accomplished.
- State law considerations – How properties are titled can impact their treatment under state laws.
Single Owner Structure
Holding investment property under a single-owner structure means one person (or an entity like an LLC or trust controlled by an individual) retains sole ownership and the exclusive right to sell, exchange, or otherwise dispose of the property. This simple ownership structure avoids the complexity of shared investments.
The single owner of the relinquished and replacement properties can readily satisfy the “like-kind” requirement. Constructive receipt risks are also minimized without co-owners involved.
However, the single owner has unlimited personal liability for legal claims against the properties. And sole ownership can limit financing options compared to jointly held properties.
Multiple Owner Structure
An alternative ownership solution is to share interest in 1031 investment properties with other co-investors. This expands financing and risk mitigation capabilities. However, the like-kind stipulation introduces some limitations on how multiparty ownership can be structured.
Partnership/LLC
Investors can pool funds into a partnership or LLC that serves as the sole owner of relinquished and replacement properties. While this looks like joint ownership, it satisfies the like-kind requirement because the partnership stake is technically the asset that gets exchanged.
The actual real estate still has a single (entity) owner. Personal assets are usually shielded from liability claims against the LLC or limited partnership’s properties.
Tenancy in Common
Tenancy in common establishes joint, undivided ownership rights between multiple investors without the right of survivorship. It facilitates shared investment in 1031 qualifying properties.
With larger ownership interests pooled, investors can access more financing and mitigate risk across a diverse portfolio of collectively owned replacement properties.
However, owners are subject to personal liability, and managing the partition process can get complex if a co-tenant wishes to sell their fractional interest.
Delaware Statutory Trusts
As an alternative to tenancy in common, Delaware statutory trusts (DSTs) enable more minor undivided fractionalized interests in 1031 investment properties. This structure provides liability protection that is lacking in straight co-ownership agreements.
DSTs satisfy like-kind exchange technicalities by having investors swap the trust share certificates, not the fractional real estate assets. The trustee retains sole ownership rights over the actual underlying properties.
The limited liability and securitized format of DSTs facilitate shared large-scale investments in replacement properties while mitigating risks for individual investors.
The 1031 Exchange Intermediaries team can successfully complete your transaction regardless of your 1031 exchange real estatestructure. Explore our strategies today.
How to Determine Which 1031 Exchange Real Estate Ownership Structure Is Right for You
When considering an ownership structure for a 1031 exchange of investment real estate, there are several key factors to evaluate to determine the best fit for your specific situation and goals:
State Law Considerations
The location of the exchange of real estate and the ownership entity’s domicile can have legal and regulatory implications. While a 1031 exchange is governed by federal tax law, state laws regarding entities, property rights, and taxes may vary and impact the operation and success of the investment. Some states may also have additional requirements or taxes on real estate transactions that can affect the 1031 exchange process.
Tax Implications
Understanding the tax consequences of different ownership structures is central to planning a 1031 exchange. While the exchange is intended to defer capital gains taxes, the ownership structure can affect future tax liabilities, estate planning, and succession issues. For example, using an LLC might offer pass-through taxation, whereas other entities may have different tax considerations. Ensuring IRS compliance regarding the continuity of investment and the types of properties involved is crucial to maintaining the tax-deferred status of the exchange.
As a real estate investor or agent guiding clients, it’s critical to carefully weigh each of these key factors. Making the right choice of ownership structure from the start can have significant long-term impacts in areas like taxes, legal liability, inheritance planning, and more.
Control over Management
Decision-making control is a key consideration in a 1031 exchange. You’ll retain full control over property decisions if you opt for sole ownership. However, structured entities like TICs or DSTs come with a predefined set of rules where management responsibilities may be delegated to a sponsor or a manager, impacting your control over the property. It’s vital to establish a clear agreement that outlines the decision-making processes and the extent of control each investor has to avoid future conflicts.
Complete Your 1031 Exchange With the 1031 Exchange Intermediaries Team
Regardless of your 1031 exchange real estate ownership structure, partnering with the right provider is essential for ensuring a successful transaction. The 1031 Exchange Intermediaries team has over two decades of experience with the following exchange types:
Contact us today to learn more about our strategies.
