1031 Exchanges for Partners, Partnerships and LLCs

One of the common questions I frequently receive is if partnerships can participate in a 1031 exchange. Indeed, they can. But, as with any transaction operating under Internal Revenue Code regulations, there are specific requirements and methods which partnerships (or partners) must follow in order to be compliant. As a taxpaying entity, a partnership (and a limited liability company taxed as a partnership) can engage in a like-kind exchange under IRC Section 1031 to defer capital gain taxes.

Challenges occur, however, when individual partners want different outcomes from the sale of a property owned by the partnership. For example, some partners may want the partnership to stay together and complete an exchange while others look to do their own exchange with their portion of the property. Still others may wish to receive cash and simply pay the tax upon sale. What options are available for these different desires?

Going Solo

For partners interested in conducting separate exchanges, the exchanger must first own real property to do a 1031 exchange. Just because a partnership owns a property does not mean the individual partners have an ownership interest in that asset (which is independently exchangeable). Since the partners simply own partnership interests – and partnership interests are not real property – a partner would have to convert his or her partnership interest into an interest in the real property owned by the partnership in order to proceed with an exchange.

Drop and Swap

One approach for accomplishing this, known as a “drop and swap,” involves the liquidation of the partnership interest by distributing a different type of interest in the real property owned by the partnership. This liquidation is the “drop” portion. The (former) partners now have converted their partnership interests into exchangeable interests in the underlying real property itself, as tenants-in-common with the partnership. The property can then be sold, with the former partners each entitled to do what they wish (sale or exchange) with their respective interests.

Related to the “drop and swap” is the “swap and drop.” This involves the same two steps but in reverse order. The partnership completes the exchange (the “swap”) and then distributes an interest in the replacement property to the departing partner or partners. Both processes may sound complex, but they are quite common when partners have different objectives on the sale of partnership-owned property.

Time Matters

Caution is warranted when considering either the drop and swap or swap and drop options. If the drop and the swap occurs in too short of a timeframe, regulators may question if the taxpayer ever truly owned a qualifying interest in the property. Clearly, the more time that passes between the “drop” and the “swap” (or vice versa), the less likely the transaction would be question or scrutinized.

While there is federal case work supporting some measure of taxpayer-friendly authority against IRS challenges, some states, like California, take a much more aggressive position on partnerships conducting 1031 exchanges.

Take the Cash

In certain instances, some partners may want the partnership to complete an exchange, but others may want to be cashed out with the sale of the relinquished property. One way to accomplish this is for the partnership to receive cash from the sale in an amount enough to purchase the departing partners’ partnership interests. This cash, however, would be considered “boot,” and would require the partnership to apportion the gain to all partners.

PIN Method

Is there a way for the remaining partners to avoid the “boot” referenced above? There is with an approach known as a partnership installment note (“PIN”) transaction. With this method, the “boot” is only recognized by the departing partners. Here’s how it works. Upon the sale of the relinquished property, the partnership receives an installment note in the amount needed to cash out the departing partners, which is then transferred to the departing partners 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 should be taxed under the Section 453 installment method and recognized only when the actual payments are received by the departed partners.

The 761 Exception

As mentioned, partnership interests don’t qualify for application of 1031 exchange. However, a narrow exception applies to a partnership that has elected, under Section 761(a), to not be subject to the partnership taxation provisions of Subchapter K. The election applies only to a partnership:

• organized and operating for investment purposes only and not for the active conduct of business
• where the partners each directly hold title to the property as co-owners
• where each owner reserves the right to separately take or dispose of his or her share of the property
• which has no active trade or business

If a partnership owning real property makes such an election, a partnership interest will be treated as an interest in the underlying assets and can be exchanged under 1031.

I hope this information has been helpful in providing insight on how partnerships can operate within the exchange guidelines of IRC Section 1031.

For more information, please feel free to contact me.