Over the last several months, I have written a number of articles addressing the subject of tax-deferred exchanges under Section 1031 of the Internal Revenue Code. The topics have ranged from the methods available to Silicon Valley property owners for pursuing this advantageous strategy in our unique real estate environment, to the use of the reverse exchange as a complex but fitting solution to situations where a regular exchange is unavailable or unsuitable, to the means by which an investor can convert commercial property to residential property and claim the benefits of both Section 1031 tax-deferral and Section 121 gain exclusion. In today’s blog post, I address a singular issue facing partnerships when engaging in Section 1031 exchanges—disagreement among the partners regarding the prospective exchange.
While combining the resources of multiple parties, such as in a partnership, can add significant value to the ownership and management of commercial real estate, it can also create major complications with respect to such assets. The most obvious example of such difficulties is when the partners disagree about what to do with their property. One especially thorny problem can occur when a partnership contemplates disposing of a real estate asset. Some partners may want to continue in partnership and pursue a Section 1031 tax-deferred exchange of the partnership property for a replacement property; others may want to leave the partnership and exchange their interest in the property for their own separate asset apart from the other partners; and others still may decide to cash out their share without an exchange and just pay tax on the sale proceeds. When these differences come up, careful analysis and planning are the keys to avoiding disastrous results.
In particular, if a partner desires to acquire its own commercial real estate separate from the other partners through a Section 1031 exchange, the partnership and the partner must arrange for that partner to forsake its interest in the partnership and hold title directly to a portion of the partnership property. This is because partnership interests are specifically excluded from Section 1031 tax-deferred treatment. Thus, if a partner wishes to pursue its own Section 1031 exchange, that partner must convert its partnership interest into an interest in the partnership’s real estate.
Drop and swap
One way to carry out this conversion involves liquidating the partner’s interest in the partnership and distributing to that partner an interest in the partnership’s property, commonly known as a “drop and swap.” Once the “drop” has been completed, the former partner will have converted its partnership interest into a real property interest in the real estate itself, holding title to the asset in tenancy in common with the partnership. At that point, the partnership and the former partner may “swap” their real estate, with each then being able to pursue its own exchange goals with its own separate interest in the property. In a similar fashion, the partner can continue to hold onto its interest in the partnership until completion of the partnership’s Section 1031 exchange, with the liquidation of its partnership interest and the distribution of the partner’s interest in the replacement property taking place after the exchange, which is known as a “swap and drop.”
“Drop and swap” and the “swap and drop
It should be noted, however, that both the “drop and swap” and the “swap and drop” methods are subject to indefinite holding period requirements for each leg of the exchange. Specifically, because both the relinquished property and the replacement property in a Section 1031 exchange must be “held in productive use in a trade or business, or for investment,” the “drop” to the partner of an interest in the partnership’s property, whether it happens before or after the “swap,” cannot be too close in time to the exchange, or it will not be adequately “held” and will not qualify for Section 1031 tax-deferred treatment. While there is no definitive answer for the length of time of the holding requirement, many advisers agree that one to two years is generally adequate.
Another area where disagreements can pose obstacles is when a majority of the partners want the partnership to complete an exchange, but one or more partners want to be “cashed out” from the sale of the relinquished property. One way to achieve this result would be for the partnership to take back cash from the exchange of the relinquished property in an amount sufficient to acquire the partnership interests of the dissenting partners; this cash would be characterized as taxable “boot,” however, and would require the partnership to allocate the resultant gain among all its partners. This unfortunate result can be avoided through the use of a partnership installment note transaction, which allows the partnership to shift the gain associated with the “boot” to be recognized by the departing partners alone. In such a transaction, the partnership would not receive any cash from the exchange, but would instead receive an installment note in the amount needed in order to buy out the partnership interests of the departing partners. Once the exchange has been completed, the partnership would transfer the note to the departing partners in exchange for their partnership interests. At that point, if at least one payment under the installment note would be received in the year following the exchange, the gain associated with the installment note “boot” will be taxed under the installment method of Section 453, and will be recognized only when payments under the installment note are actually received by the departing partners.
Prudent evaluation and counsel
Prudent evaluation and counsel by skilled brokerage, accounting and legal professionals are the keys to navigating the treacherous but potentially lucrative seas of tax-deferred exchanges under Internal Revenue Code Section 1031. Before embarking on such a voyage, you should review your circumstances with qualified counsel in order to map the journey, mitigate your risks, and maximize your benefits.