Will transferring ownership into an LLC cause issues if I try to complete a 1031?

Question

Hi, I have a duplex near Newark NJ that I purchased 4 years ago under my name, and have since turned into a rental a couple years back. I'm thinking about doing (my first) 1031 exchange into a 4-6 unit property. Before I begin the 1031 I'd like to transfer this property into an LLC so that my replacement property will be under an LLC, rather than my name.

Does anyone know if this could cause any issues with 1031 requirements? My worry is that since this is a brand new LLC that will take ownership of the property, it could cause a problem since there's no history with the LLC? Or is this not something I should worry about? Thank you!

Dave Foster · Answer

@Nick Sansivero, Like @Bill Brandt said, you'll probably have difficulty getting advantageous lending terms for that property in a new LLC.  However, if you get financing in your name you may not be able to contribute the property into an LLC later (you'll need your lenders permission).

And in a 1031 exchange the taxpayer needs to stay the same between the old property and the new property. With the 1031 there will also be some murkiness on the reasons why you transferred the property right before a sale. If you use a disregarded LLC that doesn't change the taxpayer. But a disregarded LLC is really only good for anonymity. And who knows how good that is with the new registration requirements.

@Nick Sansivero, is right that you may be eligible for a proration. but it is not automatic.  You can only prorate the primary residence exclusion in cases where health or a job transfer have forced you to move.

Matthew Morrow · Answer

It's important to consult with a tax advisor or real estate attorney for personalized advice, as this is a complex area. Generally, transferring property into an LLC before a 1031 exchange can be tricky. The IRS requires that the same taxpayer who sold the relinquished property must purchase the replacement property. If the property is transferred to a new LLC, it might be seen as a different taxpayer, which could potentially disqualify the exchange. However, there are structures and methods that might allow such a transfer without jeopardizing the 1031 exchange, but they require careful planning and legal guidance.

Denver McClure · Answer

Hey @Nick Sansivero, I recommend reaching out to a QI like @Whitney Nash. She's helped several investors from BiggerPockets!

Bill B. · Answer

Ask @Dave Foster for any 1031 questions…

But I’d start with these…

Are you planning to pay all cash for the replacement property since it will probably be either impossible or expensive to get the loan in the LLC’s name.

Why are you putting the property in an LLC? There’s no privacy advantage any more with the new federal registration law, there’s no tax advantage, and there’s probably no liability advantage. As you will likely be sued personally at the same time the property is. (Try to imagine a way that the property hurts someone bad enough to lose the property that isn’t at least partially your fault. Plus you personally are 10x more likely to be sued for something you do in which case the LLC doesn’t help at all.

If you insist on an LLC, to complicate your life and waste time and money, why not wait until after the 1031 exchange is complete?

Bill B. · Answer

I THINK you’ll find it’s advised to do the exchange afterwards (even though 99% of LLC’s are disregarded so it’s a lending issue not a tax issue.) but if @Dave Foster doesn’t chime in reach out to him in a PM. He’ll have a definite answer, not a guess like me.

Luis Alvarez · Answer

@Nick Sansivero I will preface this with the fact that I have a legal background, specifically with estate planning and asset protection.  However, this is not specific legal advice to you, just an opinion based on the circumstances described.

Do I Need an LLC to Invest in Real Estate?

The short answer is No, you don't need it.  A better question is "Should I have a rental property in an LLC?", the answer there (to me) is Yes.  I would never own rental properties in my personal name. Yes, there are many out there that do it and nothing bad has ever happened, and I say kudos to that, I just would never do that. Second, in terms of asset protection, LLCs are not invincible, but I think what many don’t understand is that they are not designed to completely shield your assets from liabilities, on the contrary they are designed to contain and isolate liabilities. They keep inside liabilities inside and outside liabilities outside. Read that again. The reason you see a person’s name and all their entities listed in a lawsuit is because Plaintiff (the suing party) attorneys have to list everyone and every entity that can be remotely tied to a cause of action, otherwise, if enough time passes and through the legal process discover that a separate entity or just a person was truly liable and they didn’t name them in the lawsuit, they are out of luck. Basically, they name everyone because they’re hoping and counting on the fact that people set up their own LLCs and didn’t adhere to basic entity maintenance (operating agreement) and kept things separate (like bookkeeping and separate bank accounts).

Transfer from personal name to LLC/Due On Sale Clause

If one is transferring property title from personal name, a Grant/Warranty Deed would be drafted/recorded to transfer title. NOT a Quitclaim Deed, because Quitclaim Deeds do not fully warrant the rights and covenants of property as does a Grant and/or Warranty (or equivalent depending on state) does.  Most purposes that people on the BP forums are transferring properties to an LLC, would be exempt of the Due On Sale Clause.  There is statutory, and now Fannie/Freddie guidelines, that exempt many transfers from being subject to the Due On Sale Clause...asset protection/estate planning purposes are typically covered.

Why Use LLC when an Umbrella Policy Does the Same?

Umbrella Policies are good, but they are not an asset protection tool, they only cover litigation/damages after you’re already in litigation or found personally liable. Also, most Umbrella Policies only pay out if your underlying policy pays out, and the underlying policy will do everything they can to find an exclusion or that you were negligent (which you probably were) in the cause of action to get out of paying the claim. And yes, attorneys make money from forming LLCs, but they make way more when you were negligent and didn’t know what you didn’t know and end up in a lawsuit.

All this being said, LLCs confuse lenders because they don't understand that most of the time they are disregarded entities (for tax purposes) and rather than try to go another level to understand what the borrower is doing, they just outright give unfavorable lending terms.  Which is why I avoid involving an LLC on my property until all the dust settles.  Once the transaction is done, I transfer my property to an LLC (on its own) and sleep good at night that any liability that happens will remain within that LLC.

Dave Foster · Answer

@Kevin Harwood Not every QI will have experience in this unfortunately.

A husband/wife LLC can be disregarded in community property states.  Otherwise you would need to set up either one disregarded LLC in one of your names.  Or use two disregarded LLCs with each of you as the sole member.

From the 1031 perspective it will not make a difference.  Here's why

You were the seller so the exchange is in your name.  But it was reported on your joint tax return with your wife (as long as you file a joint tax return).  So in reality the IRS already recognizes you and your wife as the tax payer and exchanger (becuase of the joint tax return reporting the activity of the property).

Here are your options to purchase

1. As yourself (property stays on the same tax return)

2. As a husband/wife disregarded LLC (in a community property state) - property stays on the same tax return.

3. As a disregarded LLC with only one of you as the member - property stays on the same tax return.

4. As two disregarded LLCs with one of you as the member of each - property stays on the same tax return.

5. As you and your wife as joint tenants - property stays on the same tax return.

All of these options are available to you.  As long as the new property is reported on your personal joint tax return your 1031 is fine.

Kevin Harwood · Answer

Great info folks.  @Dave Foster - how would you move capital from residential investments into commercial multi-families through a 1031 then?

We'd like to move into 5+ units and purchase a new CRE investment in a new LLC. However, our residential SFH investments we're selling are all in our names (or at least our trust). It sounds like the lenders won't really allow us to change the name on the loan after purchase typically and if we buy in the properties through the LLC the 1031 exchange would be disqualified. Any recommendations on ways to thread this needle?

Nick Sansivero · Answer

@Bill Brandt Thanks for that info Bill. My plan was to put about 20% down. I still need to speak with a lender to understand my loan options. I wasn't aware that having an LLC would make it as challenging as you mentioned. As far as why I was considering an LLC - it seems like there's two camps, those who think it's a necessity for legal protection, especially as you grow in unit count, and those who think it's mainly a waste of time and money. I've been mostly torn on this issue, which is why I haven't transferred it out of my name yet. So I appreciate your perspective here as I make a decision..And the reason I wanted to transfer it to an LLC now instead of after the 1031 is complete is mainly precautionary, because I have approval from my lender now to complete the transfer, whereas I'm not sure if my future lender for the replacement property will allow it and decide to trigger the due on sale. But perhaps that's not something I should worry about?@Russell Brazil I did live in it, but not for 2 years unfortunately

Will transferring ownership into an LLC cause issues if I try to complete a 1031?

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