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Partnership 1031 Transaction Issues

August 21, 2018

In addition to covering both the basics, and different variations, of Section 1031 transactions – such as delayed exchanges, reverse exchanges, improvement exchanges and so forth – it’s also important to discuss at least some of the recurring issues in 1031. Section 1031 exchanges can present a wide range of complex issues. Luckily, there are some issues which tend to come up much more frequently than others. For instance, in the 1031 industry, issues relating to partnerships are among the most common. One of the core 1031 rules is that the entity that sells relinquished property is also the one which acquires replacement property.  Furthermore, since partnerships often hold title to property, it shouldn’t surprise that these issues regularly arise.  In this blog post, we will go over a few of the more significant issues presented by partnership 1031 transactions.

As we will see, if all of the members of a partnership wish to conduct a 1031 like kind exchange, then the partnership generally doesn’t bring up any more issues than would normally be the case in its absence. If one or more members doesn’t wish to perform the exchange, however, then tricky things start to happen. Resolving these tricky things can be complicated, time consuming and expensive. Let’s explore these issues in some detail to get a better sense of what’s involved with a partnership 1031 transaction. 

Entity Status 

Definitely the first thing which should be done is to determine the status of the entity. Before proceeding with the exchange, you need to figure out whether the entity is “regarded” or disregarded. If the entity is regarded, then it must conduct the exchange as the selling entity. By definition, a partnership is a regarded entity.  That means that it’s separate from its members for tax purposes. If the partnership owns a piece a real estate, its members themselves do not actually own the real estate.  Since the partnership itself is the tax owner, it’s “regarded”.  In that case, its members merely own stake in the partnership itself. In other words, the partnership owns an interest in the real estate, but the members own interests in the partnership.  

Any time a LLC or other business entity has more than a single member, it will be a regarded entity.  That is, unless it has only two members and those members are a married couple in a community property state. If the entity is disregarded, it’s owner can acquire in either the owner’s name or that of the disregarded entity. Hence, the first step in the partnership 1031 transaction is determining the true tax owner of the real estate. 

Drop and Swap 

If one or more partners in a partnership don’t wish to participate in the exchange, this presents a key issue. The partnership itself has to both sell the real estate and obtain like-kind property, and so if one (or more) member doesn’t wish to conduct the exchange, then this will have to be accounted for because of that member’s ownership stake in the entity (and therefore the real estate).  

Say, for example, a partnership with three member wishes to perform an exchange.  Each of the three owns 1/3 of the entity. If 1 member wants to simply cash out without performing the exchange, how can this be accomplished? There’s two main ways of dealing with this problem.  One way is to perform what is commonly referred to as a “drop and swap”.  That involves the members of the partnership first dissolving the partnership.  In the process, they convert their interests in the property into tenants-in-common.  Their resultant ownership is consistent with their prior ownership percentage in the entity.

Thus, if they each owned 1/3 of the entity, they’d each own 1/3 of the underlying real estate as tenants-in-common. Once this conversion occurs, the member that doesn’t want to conduct the exchange sells their TIC interest outright and take the cash.  Meanwhile, the other two members can sell their TICs toward the completion of the partnership 1031 exchange. 

Swap and Drop

Alongside the drop and swap, there’s also the “swap and drop.” It’s another way to address the problem.  This is simply an inversion of the first method.  Instead of converting to TICs first and then conducting the partial sale and partial exchange, the partnership performs the whole exchange.  Then the partner who wishes to be cashed out will exit the partnership at some point in the future. Both of these ways to address the problem of an unwilling member raise possible holding requirement issues.

The holding requirement is one of the core elements of 1031, and it requires that property used in an exchange must be “held for” productive use in trade or business or for investment. But it is a qualitative requirement rather than a quantitative requirement, meaning that there is no specific length of time for which property must be held for to satisfy the requirement. The holding requirement is met if all of the actions, words and evidence collectively support that the exchanger had a clear intent to hold the property for business or investment purposes. This means that, if things aren’t handled carefully, these two ways to fix the problem can end up jeopardizing the exchange. 

Partnership 1031 Transaction Assistance

We know now that the near death of the 1031 exchange is a thing of the past, so we plan to come back to partnerships in the context of 1031 by looking at some specific case examples. As mentioned, the holding requirement issue can be very tricky for exchangers, and so our readers will benefit from reviewing some concrete cases in which this issue has been brought up. The lawyers at Mackay, Caswell & Callahan, P.C., spend copious amounts of time researching complex issues like partnership 1031 transactions, and they do it in the hope of bringing better counsel to our clients. If you have a 1031 issue or other tax or business law matter, reach out to a top New York City tax attorney and we will take care of your concern in no time. 

Image credit: KMR Photography 

Comments

NYC Tax Attorney Cases – Mackay, Caswell & Callahan, PC 4 years ago

[…] person conducts a 1031 exchange, that person takes a risk, because the requirements of 1031 can be contested by the IRS. This means that the IRS may be able to challenge whether appropriate requirements are met. Of […]

The Partnership Installment Note Method  – Mackay, Caswell & Callahan, P.C. 3 years ago

[…] our recent blog post on partnership issues in 1031 exchanges, we want to continue with this same general topic.   Here we’ll discuss a closely closely […]

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Comments

NYC Tax Attorney Cases – Mackay, Caswell & Callahan, PC 4 years ago

[…] person conducts a 1031 exchange, that person takes a risk, because the requirements of 1031 can be contested by the IRS. This means that the IRS may be able to challenge whether appropriate requirements are met. Of […]

The Partnership Installment Note Method  – Mackay, Caswell & Callahan, P.C. 3 years ago

[…] our recent blog post on partnership issues in 1031 exchanges, we want to continue with this same general topic.   Here we’ll discuss a closely closely […]

Leave a comment

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