Swaps...Real Estate for LLC
by Robert V. Lally

Background:
There are few more pervasive truisms in tax than that a like-kind tax free exchange must be like-kind property for like-kind property. Since the ability to swap property on a tax free basis runs counter to the general tax rule in which the receipt of property is generally considered to be boot and boot is taxable, the like-kind rules must be taken as matters of legislative grace. Since incidents of legislative grace are few and far between in the tax world, they are not to be taken lightly.

That said, there is a position that a swap of a fee interest, or ownership interest, in real estate may be swapped for a partnership interest in an entity which holds only real estate if the entity is a single member LLC.

Technical Discussion:
Partnership interests used to present a particular problem under the tax free swap rules of IRC §1031. The IRS generally maintained that partnership interests were excluded from §1031 as a result of the parenthetical language of §1031(a), as it existed before the changes in the 1984 Act. However, the courts did not share the view that partnership interests were automatically excluded. See Meyer Est. v. Comr., 58 T.C. 311 (1972), nonacq., 1975-1 C.B. 3, aff'd per curiam, 503 F.2d 556 (9th Cir. 1974); Pappas v. Comr., 78 T.C. 1078 (1982); Gulfstream Land and Dev. Corp. v. Comr., 71 T.C. 587 (1979).

The 1984 Act amended §1031 to provide that interests in a partnership do not qualify for like-kind exchange treatment.

Note: The Revenue Reconciliation Act of 1990 (1990 RRA) added a sentence to §1031(a)(2) to provide limited relief in this area. Under the measure an interest in a partnership that has, in effect, a valid election under §761(a) to be excluded from the application of all of subchapter K, is treated as an interest in each of the assets of the partnership and not as an interest in a partnership. This treatment applies to all transfers after July 18, 1984. However, the §761(a) exclusion is very limited. It applies only to an "organization" if it is availed of :

§761(a)(1) for investment purposes only and not for the active conduct of a business,

§761(a)(2) for the joint production, extraction, or use of property, but not for the purpose of selling services or property produced or extracted, or

§761(a)(3) by dealers in securities for a short period for the purpose of underwriting, selling, or distributing a particular issue of securities, if the income of the members of the organization may be adequately determined without the computation of partnership taxable income."

Fortunately, in a distinction which may defy full scrutiny, the IRS views LLCs (or at least single member LLCs) differently from partnerships. Whereas a partnership interest is clearly excluded from like-kind exchange treatment by the language of the statute, an ownership interest in a limited liability company is not. While not addressing the exchange of an interest in one limited liability company for an interest in another, the IRS ruled in PLR 200118023 that a taxpayer's acquisition of a limited liability company that is a disregarded entity for federal tax purposes would be treated as an acquisition of the property held by the limited liability company.

Text PLR 200118023:

IRC Section 1031
Document Date: January 31, 2001
Number: 200118023
Release Date: 5/4/2001
Index No.: 1031.00-00
Person to Contact: J. Peter Baumgarten 50-00407
Telephone Number: (202) 622-4950
Refer Reply To: CC:DOM:IT&A:5 PLR-114061-00

Dear ...

This responds to Taxpayer's letter, dated July 19, 2000, and a supplemental submission dated August 24, 2000, requesting a private letter ruling as to the application of §1031 of the Internal Revenue Code ("Code") to the proposed transaction. Specifically, Taxpayer requests a ruling that acquisition of an exchange accommodator (QI), which, as an LLC, is a disregarded business entity for federal tax purposes, will be treated as the acquisition of qualifying like-kind replacement property.

QI is a single member LLC organized under the laws of State X. It has not elected to be classified as an association pursuant to §301.7701-3(c) of the Procedure and Administration Regulations. Its sole member is XX. To facilitate an exchange with Taxpayer of RQ for RP, QI acquired RP. RP consists of real property selected by Taxpayer, on which XX constructed improvements to Taxpayer's specifications. The conveyance of RP to Taxpayer would be subject to a real estate transfer fee under State X law. However, the transfer of the ownership interest in an LLC, such as QI, to Taxpayer would not be subject to the real estate transfer fee. To avoid incurring a liability for the local real estate transfer fees incident to the transfer of RP by QI, Taxpayer proposes to simply acquire QI from XX.

Section 301.7701-2(c)(2) provides that, in general, a business entity that has a single owner and is not a corporation (as defined in §301.7701-2(b)) is disregarded as an entity separate from its owner for federal tax purposes unless the entity elects to treat itself as an association for federal tax purposes. Because QI, as an LLC, will be disregarded as an entity separate from its owner, the receipt of the ownership of QI by Taxpayer is treated as the receipt by Taxpayer of RP owned by QI.
Accordingly, Taxpayer's receipt of the sole ownership interest in QI, which owns RP, will be treated as the receipt of RP directly by Taxpayer for purposes of qualifying the receipt of such RP for nonrecognition of gain under §1031.

The above ruling applies only to the extent property held by QI at the time it is transferred to Taxpayer is property of a like kind to RQ, to be held for use in Taxpayer's trade or business or for investment. Non-like-kind property held by QI, if any, will be taxable to Taxpayer as boot. In addition, any other (non-like-kind) property transferred to Taxpayer, incident to this exchange, will be taxable boot to Taxpayer, regardless of whether Taxpayer first receives the ownership interest in QI. No determination is made by this letter as to whether the described transaction otherwise qualifies for deferral of gain realized under §1031.

Except as specifically ruled above, no opinion is expressed as to the federal tax treatment of the transaction under any other provisions of the Code and the Income Tax Regulations that may be applicable or under any other general principles of federal income taxation. No opinion is expressed as to the tax treatment of any conditions existing at the time of, or effects resulting from, the transaction that are not specifically covered by the above ruling. This ruling is directed only to the taxpayer(s) who requested it. Section 6110(k)(3) of the Code provides that it may not be cited as precedent.

Sincerely yours,

Assistant Chief Counsel
(Income Tax & Accounting)
By: Robert M. Casey
Senior Technician Reviewer
Branch 5
CC:

The private letter ruling has certain unique features. The LLC did not exist prior to the swap and appears to have been created solely for the purpose of effectuating the transfer without paying the state transfer tax (an interesting case of conflicting public policy which we leave for another day).

The language of the ruling also somewhat self-servingly begs the question by calling the LLC an "exchange accommodator.” Exchange accommodator is not a term of tax art. It is a term used only in this letter ruling. It would appear to be an invention of the ruling's author. Also interesting is the use of the abbreviation for the LLC as "QI". One suspects that this is stolen from the argot: qualified intermediary. "Qualified intermediary" is a term of tax art, but is clearly not applicable in this context. One wonders about the author's craftsmanship in this letter ruling.

It is interesting to note that despite the unique fact pattern, the language of the ruling is broad. The operative phrase being: "Accordingly, taxpayer's receipt of the sole ownership interest in QI, which owns RP, will be treated as the receipt of RP directly by Taxpayer for purposes of qualifying the receipt of such RP for non-recognition of gain under § 1031."

The question of whether such a swap could be done for an LLC with more than one member which is not a disregarded entity will have to wait for another day as well. It is interesting to note that permitting a swap for a single member LLC essentially opens the door for other swaps since the single member LLC could admit new partners the next day and presumably cease to be a disregarded entity. Once again, we leave the heavy lifting to others.

Of course, private letter rulings are "private" and not intended to serve as sweeping precedent. Nevertheless, in this case, since the outcome seems fairly pedestrian, it is probably safe to rely upon this ruling despite its technical limitations and self-serving language as precedent for others.