Partnership Issues in a 1031 Exchange

Part I: Advanced Planning Options

(This is part one of a two-part series with relevant information for real estate investors involved in partnerships.)

An important issue when addressing partnership exchanges is the investment objective of the various partners. When all of the partners want to exchange, it’s easy to structure an exchange under Section 1031. It is, however, more difficult when partners have different investment objectives.

Under IRC §1031(a)(2)(D) the IRS expressly prohibits the exchange of partnership interests in a 1031 exchange transaction. §1031 precludes such exchanges regardless of whether the interests exchanged are general or limited partnership interests.

A commonly asked question we receive is “how can individuals that hold title in a partnership go their separate ways?” Some may want to cash out; others may want to continue down the 1031 Exchange path. Most partnership issues can be resolved with advanced planning and communication. Here are three options available in such a scenario:

Distributing an undivided interest Many practitioners believe that there is minimal risk of an exchange being disallowed on audit if the “cash out partners” receive a distribution of their partnership interest as an undivided interest prior to the closing of the sale. As long as there are at least two partners (one of which was a partner prior to the redemption), the remaining partnership can complete the §1031 exchange. At closing, the surviving partnership and each of the former partners convey their interests in the Relinquished Property, with the former partners receiving cash.  The Qualified Intermediary receives the net proceeds due the  partnership, which enables the partnership to  complete the exchange when it locates Replacement Property. Completing the redemption of the cash-out partners as far in advance of the sale, and if possible, prior to the execution of the contract of sale, is highly desirable.

Liquidate partnership and distribute tenancy-in-common interests: Liquidate the partnership prior to the exchange, and distribute a tenancy-in-common interest to each partner. It is advisable to transfer ownership to the individual Exchangers as far in advance of the exchange as possible. If a distribution or dissolution occurs shortly prior to the exchange (or shortly after the exchange), the key issue is whether the Relinquished Property (or Replacement Property) was “held for productive use in a trade or business or for investment purposes.”  This qualified use requirement must be met by the individual Exchanger for the exchange to be valid, and is problematic when the distribution occurs within close proximity to the sale or purchase transaction. Conversely, the qualified use issue may be avoided by distributing an undivided interest to the cash-out partners prior to sale, thereby allowing the partnership to survive and complete the exchange.

“Drop and Swap” and “Swap and Drop”:  “Drop and Swap” transactions occur when a Partnership distributes the Relinquished Property to the partners shortly before the exchange. Conversely, “Swap and Drop” transactions occur when the Partnership distributes the Replacement Property to the partners shortly after the exchange. These transactions are considered aggressive since the partnership’s prior holding period is not attributed to the individual Exchanger. Hence, the Exchanger may not be able to satisfy the §1031 qualified use (“held for”) requirement.

Timing, again, is crucial for all of these options. Consult with your tax adviser and contact Peak Exchange for more information.