Partnership Considerations When Structuring 1031 Exchanges
Partnerships were quite often the entity of choice during the 1960s, 1970s and even well into the 1980s when investors wanted to pool their resources together for a common investment purpose, especially when investing in large real estate projects. Partnerships were a very convenient and efficient way to combine investors and pool their funds for co-investment purposes.
The partnership was very attractive because it provided liability protection for the individual investors or partners so that the partners' personal assets were not exposed to potential liability, and the partnership was a "pass-thru entity" so that the income tax consequences were "passed-thru" to the underlying partners' personal income tax returns.
Partnership Interests Excluded From 1031 Exchange Treatment
Unfortunately, as we have learned over the last few decades, partnerships 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.
Real Estate Ownership
It is important to understand the distinction here. The underlying investment property is owned by the partnership and not by the underlying partners. The underlying partners merely own a partnership interest in the partnership entity. This partnership interest is a personal property interest and not a direct ownership interest in the underlying real estate.
This is a critical distinction to understand when planning and structuring a 1031 Tax Deferred Exchange transaction involving real estate owned through a partnership. Individuals wishing to complete a 1031 Tax Deferred Exchange must sell a direct interest in real estate (fee title) and subsequently acquire a direct interest in replacement real estate (fee title).
1031 Exchange Structural Problem
Partnerships can dispose of real property and defer the corresponding income tax liabilities by acquiring like-kind replacement property as part of a 1031 Exchange transaction provided the 1031 Exchange is completed at the partnership level. However, extremely complex income tax issues arise when the underlying partners each have different investment goals and decide to go separate directions. Advanced legal and tax planning is crucial to prevent disallowance of the 1031 Exchange when this occurs.
The typical problem with dispositions of investment property owned and held by a partnership is that some of the partners will want to cash out and pay their respective income taxes at the close of the sale of the investment property and some of the partners will want to structure a 1031 Exchange transaction in order to defer the payment of their capital gain and depreciation recapture income tax liabilities from the sale of this investment property. Those who want to structure a 1031 Exchange do not typically want to stay within the partnership, but would prefer to go their own way. Therefore, a 1031 Exchange at the partnership level is not usually an option, although it can be if some of the partners do in fact wish to stay together.
The issue here is that the individual partners do not own an interest in real property; they own an interest in a partnership and will only be receiving a cash distribution from the partnership upon the close of the sale transaction. Partnership interests and/or distributions of cash can not be 1031 Exchanged. Real estate must be exchanged for other investment real estate.
There are numerous potential solutions available depending on the goals and objectives of each of the individual partners. I have outlined a number of potential strategies below, but we need to determine what each partner’s goals and objectives are in order to determine what solutions or strategies might be suitable. It is also critical that each partner have their own legal and tax advisors review their individual situation before proceeding.
1031 Exchange Structural Solutions
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 From 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 From 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 can not defer their income tax liabilities by completing a 1031 Exchange because interests in a partnership are personal property interests and can not be exchanged for an interest in real property.
There are numerous variations to the strategies briefly described above, so we would need to discuss this in more detail with the partners to see what might be appropriate and what would absolutely not work. We would be happy to discuss your circumstances with you to determine what options might be suitable.
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