What to consider when structuring 1031 partnership exchanges
Over the last few decades, we’ve learned that partnerships can cause significant planning problems for partners and their tax advisors. Partners are not permitted to sell or dispose of their partnership interest and subsequently defer the payment of their capital gain taxes by acquiring like kind replacement property through a 1031 Tax Deferred Exchange transaction.
Partnership interests are specifically excluded from 1031 Exchange treatment under Section 1031 of the Internal Revenue Code. Partnership interests are personal property, and are not considered to be like kind to the acquisition of real estate, even though the underlying assets held within the partnership are in fact real property.
However, with proper advanced tax planning, partners can restructure their ownership position so that they could qualify for a future 1031 Tax Deferred Exchange transaction involving the underlying real estate held in the partnership entity.
The partners may either sell their individual interests in the partnership, or the partnership can sell the real property and distribute the cash to the underlying partners so that each individual partner can go their separate way. There is no 1031 Exchange completed here. Neither solution is particularly desirable, as both have undesirable income tax consequences.
The sale of partnership interests are specifically excluded from tax-deferred exchange treatment under the rationale that a partnership interest is a personal property interest and not a real property interest, so more complicated structural solutions are required when partners desire to go their separate ways and some or all of the partners wish to structure and complete a 1031 Exchange.
The following structural solutions should be considered as possible strategies provided the partners have sufficient time to properly plan and implement these strategies and are willing to work together in order to do so.
The various strategic solutions include the following:
- Dissolving the partnership pursuant to Section 708 of the Internal Revenue Code and paying the taxes.
- Certain partners or new investors acquire those interests from those partners wanting to cash out and pay their income taxes, and the partnership completes a 1031 Exchange.
- Having the partnership complete a 1031 Exchange, then refinancing the acquired like-kind replacement property(ies) after a short period of time and distributing the cash to partners who do not want to participate in the 1031 Exchange transaction (buying back the interests of those who want to cash out).
- Having the partnership complete a 1031 Exchange at the partnership level and then reorganize after a period of time under co-tenancy ownership, where two or more owners each hold an undivided fractional interest in property, then distributing property according to each co-tenants’ pro-rata interest. The partnership should hold the replacement property for a sufficient length of time in order to prove the intent to hold the property as rental or investment property in order to qualify for 1031 Exchange treatment (a holding period of 24 months or more is recommended given the recent changes to IRS Form 1065). This is commonly referred to as a ‘Swap and Drop’ strategy.
- Having the partnership reorganize under co-tenancy ownership where each owner has an undivided fractional interest in property then allowing each co-owner pursues its individual investment goals. The tenants-in-common should hold the replacement property for a sufficient length of time in order to prove the intent to hold the replacement property as rental or investment property in order to qualify for 1031 Exchange treatment (again, a holding period of 24 months or more is recommended given the recent changes to IRS Form 1065). This is commonly referred to as a ‘Drop and Swap’ strategy.
- Having the partnership submit a valid election pursuant to Section 761(a) to opt out of the application of Subchapter K. To do so, the partnership interests must be treated as interests in individual assets, as distinguished from an interest in a partnership. Further, the partnership must be organized for investment purposes (as opposed to business purposes) and must not offer any auxiliary business services above and beyond those customarily associated with the investment either directly or through an agent.
- This election is generally utilized when a group of investors that is not formally organized as a partnership and does not file a IRS Form 1065 (Partnership Return Tax Return) is concerned that they may be construed to be a partnership. This election will generally not work if the group of investors is a formal partnership and does file IRS Form 1065, so I do not think this will be applicable in your situation.
If a partner or group of partners disposes of their partnership interests they cannot defer their income tax liabilities by completing a 1031 Exchange because interests in a partnership are personal property interests and cannot be exchanged for an interest in real property.
For further variations on the strategies described above, contact a ShindelRock tax professional today to determine what options might be suitable.