Partnership Considerations When Structuring 1031 Exchanges
Partnerships, as they pertain to 1031 Exchanges, take many forms. There are general partnerships, limited partnerships, joint ventures, joint tenancy, Corporations, LLCs, etc. The IRS recognizes a partnership as a single entity, a single person. This “person” may exchange real estate, but the individuals who make up the partnership may not exchange their individual shares. This creates a problem when one or more persons wish to break out of the partnership and go on their own without paying capital gains tax. The only exception to this restriction is if ownership is held in tenancy-in-common (TIC) because the IRS will consider that each owner holds the equivalent of a separate piece of real estate and can trade that piece for another property of their own.
Many investors are in a partnership or wish to enter one that is already formed. If their partnership is not a TIC, it may be possible to convert. General partnerships and joint ventures may be converted with little problem. Limited partnerships, corporations and the like cannot usually be converted.
The conversion of the partnership to TIC allows the investor to accomplish the desired exchange. There are two basic solutions to navigate, each with its own benefits and pitfalls.
The drop and swap approach describes an exchange where a partnership interest is converted to TIC before the exchange takes place. The question of timing is the largest issue in this technique. Members of the partnership have two options in dissolving the partnership prior to the exchange taking place:
- Convert the property from partnership to TIC at least a year in advance.
- Convert the property from partnership to TIC in escrow.
The swap and drop approach describes an exchange where a partnership interest is converted to TIC after the exchange takes place.
Partnerships are formed for different reasons, and that is why there is so much variety. Each form of partnership has advantages and disadvantages that should be reviewed by a qualified attorney. The attorney can help determine whether it is possible to convert a particular form of ownership and when to do it.
A great deal of confusion and misinformation is generated by partnership exchanges. If you intend to invest with others, TIC ownership structure is the preferred form of partnership because it allows the individual investor the ability to exchange into and out of particular investments while utilizing section 1031.
Both the “drop and swap” and the “swap and drop” alternatives raise potential holding period issues. If the “drop” occurs close in time to the “swap” (or vice versa), there may be some question as to whether the relinquished property (or replacement property) was “held for investment.” Also, if the drop appears too close in time to the swap, the partner’s exchange may be deemed an exchange by the partnership under the Court Holding case. Clearly, the more time that passes between the “drop” and the “swap” (or vice versa), the better.
Regarding the above issues, a line of federal cases provides taxpayer-friendly authority against challenges by the IRS. However, some state taxing authorities aggressively challenge exchanges, and argue that they are not bound by these federal cases. Also, changes made in 2008 to the federal partnership tax return make it easier to detect when drop and swap transactions have occurred, thus making such transactions more vulnerable to challenge by taxing authorities.
In some instances, a majority of the partners may want the partnership to complete an exchange, but one or more of the other partners may want to be “cashed out” with the sale of the relinquished property. One way to accomplish this is for the partnership simply to receive cash from the sale in an amount sufficient to purchase the departing partners’ partnership interests. This cash, however, would be “boot,” and would require the partnership to allocate the resulting gain among all of the partners.
A better alternative, known as a partnership installment note (“PIN”) transaction, results in the gain associated with the “boot” being recognized only by the departing partners. In a PIN transaction, instead of receiving cash, the partnership receives an installment note in the amount necessary to cash out the departing partner(s). The note is transferred to the departing partner(s) as consideration for their partnership interests. If at least one payment under the note is to be received in the year following the exchange, then the gain associated with the note will be taxed and recognized only when the actual payments are received by the departed partner(s).
Disclaimer: 1031 exchange made simple does not guarantee the performance of the QI's in our referral network and we can not be held liable for any misrepresentations or mistakes in regards to a 1031 exchange by one of the QI's that we refer to you. 1031 Exchange made simple does not provide tax advice nor can we make representations regarding the tax consequences of an exchange transaction. 1031 Exchange made simple is a 1031 QI Referral Network. 1031 made simple is not responsible (in any way) for the performance, creditability, and financial condition of any QI in our network. In this new economic environment it is imperative that all potential 1031 exchange customers do their own due diligence and research on any QI that they may use, on a 1031 exchange. Please verify and check the validity of the Bonding and Insurance of your QI. It may be wise to have your 1031 exchange accounts set up as separate, individual customer accounts. Our web site is to be used as a information based web site only. All parties doing a 1031 exchange must consult their tax advisors or attorney for this information.
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