Tax Nothings Are Something in Like-Kind Exchanges
Creative real estate investors have more options in structuring complex like-kind exchanges through a recent Internal Revenue Service (IRS) ruling on "tax nothings," or federally untaxed single-member limited liability companies (LLCs) that elect not to be treated as associations.
The September 15, 1997, Private Letter Ruling 9751012 involved a foreign corporation that owned the majority of the outstanding stock of both a U.S. holding company and a U.S. operating company. The holding company owned all the outstanding stock of two subsidiaries.
In a deferred exchange, the operating company and the subsidiaries would transfer their hotel properties to a qualified intermediary, which then would transfer them to an independent third party. They would identify like-kind replacement property within the allotted 45 days.
Before acquiring the replacement property, the subsidiaries would liquidate and the operating company would merge with the holding company. The liquidations would qualify for tax-free treatment under Internal Revenue Code (IRC) Sections 332 and 334(b)(1) and the merger as a tax-free type A reorganization under IRC Section 368(a)(1)(A). Next, the holding company would form a separate LLC for each replacement property under state laws and in each case receive the sole LLC ownership interest.
Since these single-owner LLCs did not choose, pursuant to the "check-the-box" regulations on entity classification, to be treated as associations, they would be ignored for federal income tax purposes and their assets would be considered direct assets of the holding company. By the appropriate date, the LLCs each would receive one of the identified like-kind replacement properties, completing the deferred exchange.
The IRS issued a favorable ruling under Section 1031 to the holding company’s request that it be treated as both the transferor of the relinquished properties and the transferee of the replacement properties for purposes of the like-kind exchange rules, even though it did not actually make the original transfer of the properties to the qualified intermediary. This is a liberal application of the "held-for-investment" rule. The acquisition of the replacement property by each nonelecting LLC, wholly owned by the holding company, would be deemed an acquisition by the holding company.
The ruling effectively means that the use of a single-member LLC tax nothing does not violate the held-for-investment requirement, allowing the holding company to receive tax-free treatment.
The tax nothing can create some interesting planning strategies. For example, many states levy taxes on the transfer and recording of a real property deed. However, when properly planned, the use of a tax nothing as either the transferor or transferee of property in a like-kind exchange should not deny the taxpayer tax-deferred treatment. In the proper jurisdiction, a property owner could transfer property to a tax nothing, then, as part of a like-kind exchange, exchange the ownership interest for an interest in a qualifying replacement interest. Since the tax nothing is untaxed for federal income tax purposes, the like-kind exchange of the interests is viewed as an exchange of like-kind property and qualifies for tax-free treatment. Both the transfer of the property to the tax nothing and the transfer of interests in the like-kind exchange may be exempt from state transfer taxes.
This type of structure will not work if a tax nothing is placed between a property owner and a partnership that holds the real property. This structure may avoid state transfer taxes, but because the tax nothing is ignored for federal income tax purposes, the transfer of an interest in the tax nothing will be viewed as the property owner exchanging a partnership interest.