We all know that an individual or an entity can sell an investment property and complete a 1031 exchange, indefinitely deferring any tax due. But what if the property being sold is owned by a partnership or multi-member LLC and one or more of the partners wants to go their own way? In this scenario, is the opportunity off the table for those who wish to 1031 and reap the tax benefits?
Fortunately, there are six strategies that we see investors and their tax advisors use to complete an exchange under these circumstances.
Relevant Rules
Though there are a number of rules that must be followed to execute a proper 1031 exchange, the three most specific to this type of scenario are the “same taxpayer” rule, the “qualified property” rule and the implied “held for investment” rule. The “same taxpayer” rule specifies that the taxpayer selling the relinquished property must also be the same taxpayer acquiring the replacement property — tricky if some partners do not want to exchange together. The “qualified property” rule states that an ownership interest in a partnership — as opposed to an undivided tenants-in-common interest (see June, 2018’s question section) are disqualified property for 1031 purposes. Simply put, you cannot buy or sell a partnership interest in an exchange. Finally, qualified property must be “held for investment.” This phrase implies that there might be an expectation of a holding period for the property in question.
Strategy #1-“Drop and Swap”
First, let’s look at a partnership with three partners originally formed with the sole intention of owning a retail center. The partnership receives an attractive offer on the center. Two of the three partners want to sell and 1031 into separate properties, while the remaining partner wants to cash out and pay the tax. Under a “drop and swap” strategy, the partnership will “drop” (or distribute)
the property to the three partners in a tenants-in-common (TIC) format. Because the real estate being sold is the only asset in the partnership, it is important that the partnership also be dissolved at this time. (Distributing property from a partnership to the partners generally does not trigger any tax consequences.) The three new co-owners (former partners) can now each sell their one-third TIC interest in the property to the new buyer.
Mindful of the implied “held for investment” requirement, some tax professionals feel that because the co-owners are different taxpayers than the partnership, there needs to be a reasonable amount of time between the “drop and swap” and the sale. Ideally, there would be at least one tax year that separates these action steps. However, even if the partners had wanted to drop and dissolve well in advance of a sale, they may have been restricted from doing so by the lender if there was debt on the property. Even with this concern, “drop and swap” has become a common technique that many tax advisors have helped their clients structure and execute. Over the last 50 years, there have been several occasions where the IRS has challenged this type of transaction, but the tax court has ruled in favor of the taxpayer at times, particularly if their steps were well documented. Therefore, it is critical that the deed distributions, the dissolution of the partnership and other action steps are properly executed and recorded.
Strategy #2- Cashing out any partners before the exchange
A second option is for the exchanging partners to buy the partnership interest from any partner who wants to cash out before the exchange. In our previous example, this could be done by the two remaining partners. The “modified” partnership then goes forward to do the 1031 exchange. From an exchange perspective, to defer all the tax that may be due on a sale, the new property must be of equal or greater value. Buying the partner’s interest would require the remaining partners to invest more cash that then must remain in the subsequent replacement acquisition.
Consequently, this strategy works best if the partner leaving has a minimal interest and the remaining partners have additional cash to invest. Alternatively, they could have a new partner buy out the existing partner’s interest.
Strategy #3-The two exchanging partners stay together
A third option can be considered if the two partners that want to exchange are willing to invest together and involves dropping the non-exchanging partner out of the partnership. This results in the partnership, consisting of the two exchanging partners, now co-owning the property with their former partner in a TIC format. The remaining two-member partnership will go forward and complete a 1031 and the partner that was “dropped out” of the partnership will pay the tax on their portion of the sale. The “holding period” risk in this approach is that the IRS may take the position that the deed executed by the partnership to the non-exchanging former partner (the “drop”) had no economic substance and therefore the tax triggered by his portion of the sale should affect all the partners at the partnership level. It is best that some time should lapse between the closing and dropping the TIC interest to the non-exchanging party. It is also very important to immediately make the appropriate change to the tax reporting after the “drop” has been completed.
Strategy #4- Cashing out a partner after the exchange
When using this strategy, the purchase contract is amended to include an installment sale note that mirrors the equity position of the partner that wants to cash out.
The note is designed for the majority of the principal to be paid down immediately with a residual amount to be satisfied when the new tax year begins. The specific mechanics of this approach are quite complex and beyond the scope of this article.
Strategy #5- Swap with a delayed drop
If all parties want to exchange, but just prefer going their separate ways at some point in the future, they may choose to “swap” and then do a delayed drop. Using our same example, the partnership stays intact and exchanges the larger retail center for three smaller properties with values approximating each of the partners’ interest in the partnership. By using “tracking allocations” so that each partner gets most of the benefits of “their” particular property, a 1031 can be completed. Preferably after 1 year or more, the partnership is dissolved—with each partner receiving their targeted property.
Strategy #6- Continuing Partnership Division
This technique can be implemented before or during an exchange and uses the partnership division rules of under §708(b)(2) which allow one partnership to be divided into multiple partnerships. For instance, if a partnership owned by Kent and Tina is doing a 1031 and the two partners want to go buy their own property they could divide the current partnership into two partnerships, the old and the new. Kent and Tina would each own a 99% and 1% partnership interest in their respective partnership. Each partnership would acquire separate replacement property. Then, several years later, the majority partner could buy out the minority partner. The continuing partnerships are considered to be the same taxpayer for 1031 purposes, and this is one of the few partnership techniques currently endorsed by the California Franchise Tax Board.
Though there are more challenges in executing a 1031 exchange with a partnership when some of the partners have different objectives, there are strategies that can be used to still receive all of the benefits that a 1031 offers. Some of the techniques could have a certain level of tax risk and investors should always seek the counsel of their tax advisor.