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Partnerships and 1031 Exchanges

A common way to own investment real estate is as a member of a partnership. Being in a partnership has many advantages but does present a challenge if one of the partners wants to cash out using a 1031 exchange.

In the eyes of the IRS, a partnership "interest" is considered personal property and does not qualify for a 1031 exchange. The general rule that is that the "entity" that sells the relinquished property must be the same "entity" that purchases the replacement property or, a simpler way to look at it is the tax return that sells the relinquished property must be the same tax return that purchases the replacement property (there is an exception under the "disregarded entity" rule). If the partnership sells the relinquished property and the partnership purchases the replacement property then the transaction is "like kind" and qualifies for a 1031 exchange.

With careful planning and forethought the members of a partnership can structure a transaction, or series of transactions that allow one or all of the partners to cash out and "go their separate ways" while deferring capital gains taxes. A few options are:

The partnership can exchange the single property for several like kind properties with an aggregate "equal" value; allowing easy dissolution of the partnership for further exchanges. This strategy is commonly known as "swap and drop". The partnership creates separate limited liability companies (LLCs). The LLCs holds each new property for a sufficient amount of time to prove that they held it for investment to insure the exchange will be valid. The partnership then distributes the LLCs to the individual partners. Some adjustments relative to fair market value may be needed to keep the distributions equal to the respective percentage interest.

The partnership can transfer the interest in the real estate to the various owners as Tenants-In-Common (TIC). Holding title as a TIC means that each co owner has an "undivided fractional interest" in the property and provides a separate deed to each co owner. This way of holding title allows each co owner to exchange their interests separately, meaning that one can exchange into another property without the other co owners.

The partnership could purchase the replacement property and after it closes refinance and the proceeds can be distributed to the partner who wants to cash out.

The common requirement for all of these is that the property be held long enough to qualify as an investment. Doing the ground work for a successful 1031 exchange should be done long before the actual exchange happens. This is done to minimize the risk of the IRS claiming that the individual members or partners purchase the property for resale rather than for investment or that the exchange was really an attempt to exchange partnership interest which as mentioned above, is excluded as like-kind property under a 1031 exchange.

As always each investor should consult with their tax/legal professional to discuss the risks and other factors involved with partnerships prior to making any decisions.

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TM 1031 Exchange writes articles that are published in newspapers throughout the United States.
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