Real Estate Choice of Entity - Revisited

In a previous article we discussed the benefits of holding title to real estate in a limited liability company. (See: Real Estate Choice of Entity: Should Your Property be in an LLC?) Those benefits included limited liability, less formal management, and estate planning flexibility. However, there may be instances when it may not be possible to take title in an entity.

Section 1031 requires that the same taxpayer who owned the relinquished property must be the same taxpayer that acquires the replacement property. It is clear that an individual can acquire replacement property in a disregarded entity, even if the relinquished property was titled in her individual name.

But what happens if the relinquished property is owned by a husband and wife in their individual names? In general, a limited liability company (LLC) with two or more members is considered to be a partnership. That is true even if the members are husband and wife and file a joint tax return. The result would be that a different taxpayer has taken title to the replacement property, and the exchange would be disqualified.

One solution is for the spouses to each form their own LLC. Then, their respective LLCs would hold title to the replacement property as tenants in common, and each spouse can enjoy the benefits and protection of owning through an LLC. Another solution to avoid being treated as a partnership is for the spouses to form a qualified joint venture under IRC §761(f). That option requires that each spouse “materially participate” in the venture, which may make it difficult for most taxpayers to qualify.

A better result is available in community property states. A LLC owned by a husband and wife as community property can be considered a disregarded entity for federal tax purposes even though there are two members. Rev. Proc. 2002-69. A business entity qualifies if it is wholly owned by a husband and wife as community property under the laws of a state, a foreign country, or a possession of the United States; no person other than one or both spouses would be considered an owner for federal tax purposes; and the business entity is not treated as a corporation.

It is a good idea to state in the LLC operating agreement that the membership interests are community property, since the characterization as a disregarded entity is not automatic. If the spouses prefer to treat the entity as a partnership, and they file the appropriate partnership returns, the IRS will treat the LLC as a partnership for federal tax purposes. The application of community property laws will generally depend on the taxpayers’ state of domicile. Community property states are: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. See: IRS Publication 555.

Choice of a title holding entity requires careful consideration. Consult with your attorney to determine the best fit for your situation.

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