In a previous blog, we discussed the benefits of the 1031 exchange. This IRS rule allows property owners to defer capital gains taxes when they trade a property for a like-kind property. So if your client has a property that is used for business or held as an investment and exchanges it for another property that is used for business or held as an investment, they may qualify for 1031 treatment.
The matter can become more complicated when the property is owned not by an individual but by a partnership or LLC. Partnerships may be formed as a real estate investment partnership where each partner contributes different properties. Those properties likely do not have the exact same fair market value or same mortgage amount on the property, so the partners will have to formalize an agreement on how profits will be allocated when a property is sold. Since partnerships are allowed to use special allocations, the partners have a great deal of flexibility on how to set up this agreement.
A common dilemma facing partnerships is that different partners will need different things, financially speaking—this applies to the sale of a property. Some partners may not want to sell a property and pay capital gains taxes because they are in a higher bracket. Other partners may want to do a 1031 exchange but keep the partnership intact. Still others may prefer to do separate 1031 exchanges with their portion of the property. How can this partnership engage in a 1031 exchange in light of differing needs?
Remember that even if the partnership owns a capital asset, this does not mean all of the partners have an ownership interest in that asset. Partners own partnership interests, which are specifically excluded from 1031 treatment. This means that if there is a departing partner, they will first need to convert their partnership interest into an interest in the capital asset owned by the partnership.
Converting a Partnership Interest into an Interest in the Property
Partnerships have two main options for handling a 1031 exchange under these circumstances:
- Drop-and-Swap: The first method involves liquidating the partnership interest by distributing the interest in the property owned by the partnership. This can be done pro rata or according to a special allocation agreement between the partners. Once the partnership has completed this “drop,” the former partner will now have an interest in the actual property as a “tenant-in-common.” Now the partnership can engage in a 1031 exchange (the “swap”), and the former partner is free to do as they wish with their interest, including selling or exchanging the property.
- Swap-and-Drop: This alternative involves the same two steps but in the reverse order. The partnership completes the 1031 exchange (or the “swap”) and then distributes an interest in the replacement property to the departing partner in return for their partnership interest.
With both approaches, partners need to be aware of potential holding period issues. If the drop occurs at the same time that the swap does, there may be a question of whether the replacement property was actually held for investment. Remember that 1031 rules dictate that both properties must be held for business or investment purposes to be considered “like-kind.” The IRS has improved its ability to detect drop-and-swap transactions since 2008 when they updated the federal partnership tax return (IRS Form 1065), so the likelihood of being challenged by tax authorities is higher. Experts recommend leaving as much time as you can between the drop and the swap (or vice versa) to avoid ambiguity.
Using a Partnership Installment Note
One other option available for 1031 exchanges is called a partnership installment note or “PIN.” If you have partners who want to leave and reclaim their investment and others who want to keep the partnership intact, a PIN may be the right move. Say the remaining partners are interested in a 1031 exchange to dispose of a property while the leaving partners are looking to sell and receive cash. The partnership can issue a PIN to the leaving partner in exchange for their interest in the partnership. Then after the 1031 exchange is complete, the buyer of the traded property will pay the former partner directly, in accordance with the installment note agreement. This allows the remaining partners to avoid paying taxes on any gain, since they are still covered by the 1031 treatment.
Conclusion
To better prepare for the potential sale or exchange of properties, partners in a partnership should have conversations early on about how to handle their properties. This conversation should also be revisited as time goes on, since people’s needs will change. Partners may not hit life stages at the same time. Some may get married or divorced or have family members pass away. By working with a Certified Tax Planner, partners can form a tax plan that allows for as much flexibility as possible to accommodate these types of changes.
To learn more about 1031 exchanges and how to uniquely tailor tax plans to partnerships and other business entities, sign up to become a Certified Tax Planner today.
