In our last blog, we discussed the benefits of the 1031 exchange. This IRS rule allows property owners to delay paying capital gains taxes if they trade their property for a like-kind property. If both your old and new properties are used for business or held as an investment, you may qualify for a 1031 exchange.
What if the property in question is owned not by an individual but by a partnership or LLC? The original partnership may even have been formed as a real estate investment partnership where each partner contributes properties of different values. Since partnerships are allowed to use special allocations, the partners have the flexibility to decide how profits will be allocated when a property is sold.
New complications may arise if partners want different things. This can be a result of partners being in different tax brackets. Some partners may not want to sell a property and pay capital gains taxes because they are in a higher bracket. Some partners may want to do a 1031 exchange, while others may just want to receive cash and pay the taxes owed.
An important distinction to keep in mind is that partners own partnership interests. This means that just because a partnership owns an asset does not mean that all partners have ownership interest in that asset. This may seem like an odd distinction, but it matters when it comes to 1031 exchanges because the IRS specifically excludes partnership interests from 1031 treatment. So if a partner wants to exit the partnership and take their share of a 1031 property exchange with them, this will require some technical gymnastics. That partner must first convert their interest in the partnership into an interest in the actual property.
Drop-and-Swap or Swap-and-Drop?
There are two main ways to convert a partnership interest into an interest in the property:
- Drop-and-Swap: The first method involves liquidating the partnership interest. The interest in the property being traded is distributed to each partner based on the existing agreement. This is the “drop” portion of the process. Now the leaving partner has an interest in the actual property as a “tenant-in-common.” At this point, both the former partner and the remaining partnership are free to do as they wish with their respective interests, including selling or exchanging the property. When the property is sold via a 1031 exchange (the “swap” portion), the former partner and the partnership will receive their own share of the profits.
- Swap-and-Drop: This method simply reverses the order of those same two steps. The partnership completes the 1031 exchange first. Once the “swap” is complete, the partnership distributes an interest in the replacement property to the departing partner in return for their partnership interest (the “drop”).
With both approaches, timing matters. Partners may run into holding period problems—if the drop occurs at the same time as the swap, there may be a question of whether the replacement property was actually held for investment. This causes a conflict because the business or investment property must be exchanged with another business or investment property in order to qualify for 1031 benefits. The IRS has also become better able to detect drop-and-swap transactions since making changes to the partnership tax return (IRS Form 1065) in 2008. To avoid complications, a good rule of thumb is to leave as much time as you can between the drop and the swap (or vice versa).
Put a “PIN” on it
When you have partners who want to leave and others who want to keep the partnership intact, another technique available is called a “partnership installment note” or “PIN.” If 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, a PIN may be the right move. With a PIN, the leaving partner essentially trades their interest in the partnership for the installment note. After the partnership completes the 1031 exchange, the buyer of that property will make payments to the partner who “cashed out.” Both parties win: the partnership completes the tax-deferred exchange, and the leaving partner gets their cash payment.
Conclusion
Partnerships that own properties need to have conversations early on about what they may want to do with these properties in the future. The guiding assumption should be that at some point partners will need different things—some may get married or divorced or have family members pass away. Some may be in a higher tax bracket while others are in a lower one. By working with a Certified Tax Planner, partners can form a tax plan that allows for as much flexibility as possible to accommodate changes as time goes on.
For help navigating a 1031 exchange or formulating a tax plan for your partnership, reach out to Certified Tax Planner today.
