Partnership Issues When Exchanging 1031 Property

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Article by: David Wright

One of the most commonly encountered problems in a 1031 exchange involves the treatment of a partnership that owns a property to be sold. It is quite common to have one or more partners that want to end their partnership involvement and obtain the sales proceeds while other partners may wish to reinvest the sale in 1031-qualifying replacement property. Careful forward planning is required to ensure a successful 1031 exchange where partnership issues are involved.

 

First, it should be noted that, while an exchange of a tenant-in-common interest in real estate presents no statutory question within section 1031 exchange treatment, an exchange of a partnership interest is not permitted under section 1031 of the Internal Revenue Code.

 

If a partnership owns property and desires to sell and exchange it, the partnership is the exchanging party. Since the partnership will take title to the replacement property, no ownership issues occur during the exchange period. However, if the partners wish to split up immediately after the exchange, the "held for" requirement may not be met on the replacement property. The partnership would need to retain ownership of the new property for an unspecified period of time (one year is commonly thought to be sufficient) to meet the “held for” qualification. Once sufficient time has passed, the partnership can terminate and parcel out the property - through individual property deeds or tenant-in-common ownership - to the former partners. This structure, called a “swap and drop” is believed to be the more conservative option to ensure a successful 1031 exchange.

 

If a partnership wishes to exchange property but one or more of the partners want to "cash-out" or go their separate way(s), it is common for the partnership to split out the ownership before the sale. This transfer of undivided interests involves the partnership distributing tenancy-in-common title to the individual partners who wish to proceed in separate directions. The remaining partners, under the umbrella of the partnership, would then proceed with an exchange of the remaining tenant-in-common ownership in the partnership's name.

 

Frequently, individual partners desire to end the partnership relationship when the owned property is contracted for sale. While some partners may prefer to take their partnership sale proceeds as a taxable, “cash out” event, others might prefer to buy qualifying 1031 replacement property in their individual names. This structure, called a “drop and swap”, involves dissolution of the partnership ownership in favor of individually-deeded ownership interests.

 

Too frequently, partnerships wait until immediately before the property sale to distribute the undivided tenant-in-common interest to their partners. This lack of planning substantially increases the risk of harming the case for nonrecognition of gain. The entire exchange could be challenged since the partnership could be seen as the actual selling entity. Since the individual owners have only held the property in their names for a short period of time, they may be seen as not having met the "held for" requirement.

 

If partners wish to discontinue the partnership, sell the property and go their separate ways - with either the cash or a 1031 Exchange - it is necessary for the individual partners to receive deed to the property from the partnership in advance of the property sale. In a properly planned transaction, the undivided interests will be distributed before any contract is signed to sell the relinquished property. Better still, the interests would be distributed before the property is listed for sale. The longer the period between distribution to tenancy-in-common ownership and the eventual sale, the more likely the statutory “held for” requirement can be met.

 

The services of a tax professional are essential for tax planning purposes. An experienced Qualified Intermediary is also needed to ensure a successful exchange structure where partnership and co-ownership real estate interests are involved.

This information is not intended to replace qualified legal and/or tax advisors. Every taxpayer should review their specific transaction with their own legal and/or tax counsel.