Hidden Dangers of Partnerships and the 1031 Exchange

The Section 1031 “like-kind” exchange is a legal tool utilized by many investors to upgrade their real estate holdings while deferring taxation. Theoretically, investors can exchange properties indefinitely without incurring capital gains tax. However, complications can arise when these investments are made by partnerships. It is almost inevitable that somewhere along the process, a partner will want to “cash out” their investment. This can expose the entire partnership to substantial tax liabilities.

If in order to satisfy the exiting partner, the partnership’s property is sold and proceeds distributed, the remaining investors will be subject to substantial taxation on any gains. Simple strategies, such as “buying out” the exiting member or specially allocating the gain, also subject the partners to taxation. However, several options are available to a partnership facing dissolution. These include the “drop and swap”, the “swap and drop”, the “split-off”, and the installment note. With appropriate planning a transaction can be structured that satisfies both parties.

For partnerships that have seen their dissolution ahead of time, the “drop and swap” can be of great use. In this scenario the partnership makes a tax-free distribution of the investment property’s title to the individual investors. Once the individuals possess title, each investor may “cash out” or make a like-kind exchange. The key to executing this strategy is ensuring compliance with Section 1031’s “held for investment” requirement, thus this strategy requires considerable foresight.

If investors do not recognize the tax issue until just before the property is disposed, a “swap and drop” may be effective. This strategy resembles the “drop and swap” but is ordered differently. Here the partnership executes a like-kind exchange, waits to avoid IRS treatment as a “step transaction”, and then drops title to the individual partners or refinances the new property to acquire cash to redeem the leaving partner.

Alternatively, a “split-off” strategy may be effective. In a split-off, the partnership distributes tenancy in common title to the exiting partner only, then the partnership makes an exchange in its name. Since the partnership keeps title in its name, the split-off provides title continuity, satisfying the “held for investment” requirement and allowing the leaving partner to cash out or exchange their interest.

Finally, the investors may sell the original property for cash and an installment note. In this approach the partnership distributes the exiting partner an installment note equal to his interest while the remaining investors receive cash. The remaining partners use the cash to exchange into a new property and the exiting partner only recognizes gain as note payments are received.

The like-kind exchange provides real estate investors with a valuable wealth-building tool. But if the partnership dissolves, serious tax issues arise. Fortunately, with proper planning these risks can be minimized and transactions can be structured that maximize returns for all the partners.

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