Parachuting from a Partnership into a Successful 1031
We all know that an individual or entity can sell an investment property and complete a 1031 exchange, indefinitely deferring any tax due. But what if it’s a partnership that owns the property? If all of the partners want to 1031 into a new property, this is relatively simple to accomplish. However, it becomes more challenging if one or more of the partners wants to go their own way- either by purchasing their own separate property or cashing out. Fortunately, there are four strategies that we see investors and their tax advisors use to complete an exchange under this circumstance. Though there are a number of rules that must be followed to execute a proper 1031 exchange, the three most specific to this 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 the partners or entity are changing. The “qualified property” rule states that interests in a partnership-- as opposed to undivided interests in a property- are disqualified property for 1031 purposes therefore, 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.
"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-- 2 of the 3 partners want to sell and 1031 into a new property, 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 tenant-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 of the property to the new buyer.
Mindful of the implied "held for" 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 30 years, there have been several occasions where the IRS has challenged this type of transaction, but the tax court has been ruled in favor of the taxpayer at times, particularly if their steps were well documented. Therefore, it is critical that the deed distributions, the extinguishment of the partnership and other action steps are properly executed and recorded.
Cashing out any partners before the exchange
A second option is for the exchanging partners to buy the partnership interest from the partner who wants to cash out before the exchange. In our previous example, this can be done by the two remaining partners or by bringing in a new 3rd partner. The “modified” partnership then goes forward to do the 1031 exchange. Certain partnership agreements have provisions dealing with the sale of one partner’s interest to the remaining parties. However, the partner that is bought out cannot have an interest of 50% or more because the partnership will technically terminate under IRC Section 708. 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 a the partners 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.
Cashing out a partner after the exchange
When using this strategy, the purchase contract is amended to include a 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.
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 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. 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. Some of the techniques could have a certain level of tax risk and investors should seek the counsel of their tax advisor.