Win-Win: Partnerships and 1031 Exchanges
We all know that an individual can sell an investment property and 1031 into a replacement property, 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 their own separate property or prefers to cash out. There are four strategies that we have seen employed by investors to complete both the 1031 and meet all the partners’ varying objectives.
Though there are a number of rules that must be followed to execute a proper 1031 exchange, the two most specific to this scenario are the "same taxpayer" rule and the "qualified property" rule. The “same taxpayer” rule specifies that the taxpayer selling the relinquished property must also be the same taxpayer acquiring the replacement property. The “qualified property” rule states that partnership interests are disqualified property for 1031 purposes and that qualified property must be “held for” investment. With this requirement, there is an implied holding period.
“Drop and swap” First, let’s look at a partnership made up of three partners originally formed with the sole intention of owning a retail center. The partnership receives an attractive offer on the center and 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 this strategy, the partnership will "drop" (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 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 third of the property to the new buyer. Because each co-owner is selling their individual, undivided interest in the property, they can now choose whether or not to cash out and pay the tax or to go forward with a 1031 exchange.
Some tax professionals feel that, because the co-owners are different taxpayers than the partnership and of the implied “held for” requirement, 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 almost always ruled in favor of the taxpayer, 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 partner before the exchange - A second option is to buy the partnership interest from the partner who wants to cash out before the exchange. This can be done by the two remaining partners or by bringing in a new 3rd partner. The “modified” partnership goes forward to do the 1031 exchange. This works best if the partners wishing to leave have minority interests with relatively small capital accounts. Certain partnership agreements have provisions dealing with the sale of one partner’s interest to the remaining parties. However, if the partner leaving has an interest of 50% or more of the partnership, the redemption or sale of their interest may technically terminate the partnership 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. Redeeming a partner or buying their interest would require the remaining partners to invest more cash that 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 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.
Swap with a delayed drop- If all parties want to exchange but just prefer going their separate ways, they may choose to “swap and then do a delayed drop”. In this scenario using our same example, the partnership stays intact and exchanges the larger retail center for three smaller, but equal properties. 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 later, the partnership is dissolved—with each partner receiving “their” 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.