1031 Exchanges with Membership Interests—Revenue Rulings 99-5 and 99-6

Consider the situation where Chris is the sole member of Apartment LLC, a disregarded entity for tax purposes.  Apartment LLC owns a small apartment building as its only asset.  Reza has some extra cash and is looking for a real estate investment.  He asks Chris if he can buy into Apartment LLC.  Chris likes the idea, and offers to sell Reza a 40% membership interest. Chris knows there will be quite a bit of gain associated with that sale, since the apartment building has appreciated a lot over the years.  He wonders if he could use Internal Revenue Code Section 1031 and do a like-kind exchange to avoid recognizing that gain. 

Section 1031(a) provides that no gain or loss is recognized on the exchange of real property held for productive use in a trade or business or for investment [the “relinquished property”] if the real property is exchanged solely for real property of like kind that is to be held either for productive use in a trade or business or for investment [the “replacement property”].

At first, Chris is dismayed.  After all, he’s not selling real property to Reza; he’s selling a membership interest in an LLC that owns real property.  And Chris knows that Section 1031 requires very exacting compliance with its rules.  But then Chris’s friend Soyeun suggests that he read Revenue Ruling 99-5.

Situation 1 of Rev. Rul. 99-5 involves A being the sole member of a disregarded LLC, and B wanting to buy a 50% membership interest from A—very similar to Chris and Reza’s situation.  The sale of the membership interest would create a multi-member LLC, taxed as a partnership by default.  The tax treatment, according to Rev. Rul. 99-5, would be:  “B’s purchase of 50% of A’s ownership interest in the LLC is treated as the purchase of a 50% interest in each of the LLC’s assets, which are treated as held directly by A for federal tax purposes. Immediately thereafter, A and B are treated as contributing their respective interests in those assets to a partnership in exchange for ownership interests in the partnership.”

Under Rev. Rul. 99-5, therefore, Chris is treated, for tax purposes, as owning the apartment building itself, and selling a 40% interest in the apartment building to Reza.  He and Reza are treated as immediately contributing their interests in the apartment building to Apartment LLC in exchange for their membership interests in Apartment LLC.  Since Chris is treated for tax purposes as selling an interest in real property, the 40% membership interest in Apartment LLC qualifies as viable relinquished property under Section 1031.  It only works, though, when going from a single-member disregarded entity to a tax partnership. 

Now consider the situation, a number of years later, where Reza and Chris are the members of Apartment LLC, now taxed as a partnership, with Reza owning a 40% membership interest and Chris owning a 60% membership interest.  Apartment LLC still owns that same small apartment building as its only asset. 

One day Reza decides to liquidate his investment.  He asks Chris if Chris would buy his 40% membership interest in Apartment LLC.  Chris is in the process of selling a rental house he owns, and figures he could use the proceeds from that sale to buy out Reza, so Chris agrees.  Chris knows there will be quite a bit of gain to recognize when he sells that rental house. He wonders if he could use Section 1031 and treat Reza’s membership interest as replacement property in a like-kind exchange to avoid recognizing gain on the sale of the rental house. 

As we saw before, Section 1031(a) provides that no gain or loss is recognized on the exchange of real property held for productive use in a trade or business or for investment if the real property is exchanged solely for real property of like kind that is to be held either for productive use in a trade or business or for investment.

 At first, Chris is downcast.  After all, he’s not purchasing real property from Reza; he’s purchasing a membership interest in an LLC that owns real property.  And Chris knows that Section 1031 requires very exacting compliance with its rules.  But then Chris’s friend Soyeun suggests that he read Revenue Ruling 99-6.

Situation 1 of Rev. Rul. 99-6 involves AB LLC, which is taxed as a partnership, like Apartment LLC.  A and B are 50/50 partners, and B is buying A’s entire 50% partnership interest—very similar to Chris and Reza’s situation.  According to Rev. Rul. 99-6, “for purposes of determining the tax treatment of B [in buying A’s partnership interest], the AB partnership is deemed to make a liquidating distribution of all of its assets to A and B, and following this distribution, B is treated as acquiring the assets deemed to have been distributed to A in liquidation of A’s partnership interest.”

Under Rev. Rul. 99-6, therefore, Apartment LLC is treated, for tax purposes, as distributing the apartment building to Reza and Chris, followed immediately by Chris’s purchase of Reza’s 40% interest in the apartment building.  Since Chris would be treated for tax purposes as buying an interest in real property, Reza’s 40% membership interest in Apartment LLC would qualify as viable replacement property for Chris’s exchange under Section 1031.  It only works, though, when going from a tax partnership to a single-member disregarded entity.

When Chris explained all this to Reza, Reza wondered if he might also benefit from Rev. Rul. 99-6.  The apartment building had appreciated a lot in the years since Reza bought his 40% membership interest in Apartment LLC, so there would probably be significant gain to recognize on the sale of Reza’s membership interest.  Maybe Reza’s membership interest would be viable relinquished property for a 1031 exchange.

Unfortunately, Reza will not be so lucky.  Even though Chris is treated as purchasing the underlying asset (real property), Reza is treated as selling a membership interest, which is not real property.  Referring again to Situation 1 of Rev. Rul. 99-6 in which B is buying out A in AB LLC, Rev. Rul. 99-6 provides “A must treat the transaction as the sale of a partnership interest.  . . . A must report gain or loss, if any, resulting from the sale of A’s partnership interest in accordance with Section 741.”    

Author: William F. Webster, of Boutin Jones Inc., wwebster@boutinjones.com