A recurrent issue in exchanges under Section 1031 of the Internal Revenue Code (IRC) revolves around the proper structure of transactions involving partnerships (and limited liability companies taxed as partnerships). In order to have a valid exchange, a taxpayer must exchange an interest in a permitted asset for an interest in a like-kind asset. Exchanges of partnership interests (even if the partnership owns nothing but the underlying asset) are not valid for Section 1031 purposes.
When all of the partners of a partnership want to sell an asset and re-invest the proceeds into the same new property, the partnership is the "taxpayer" and makes the exchange itself. However, if the partners want to sell the partnership property, but each partner wants to do with his or her share of the proceeds as he or she pleases, tax advisors are often asked to assist in structuring the transaction to accommodate divergent interests. There are a variety of ways to do this, none of which is completely free from risk. The greatest risk in each case is attributable to timing; partners rarely anticipate the complexities of disposition and fail to seek tax advice early enough to structure acquisitions to take advantage of Section 1031 on the sale of the assets.
The following summarizes the several techniques that are used to accommodate partnership sales when not all of the partners intend to exchange into the same replacement property.
Pre-sale liquidation of the partnership - the "drop and swap." It is possible prior to the sale of the partnership's property to liquidate the partnership and distribute to each partner (generally tax-free) an undivided interest in the underlying property, to be held thereafter by the former partners as co-tenants. Each former-partner is thus an owner of an undivided interest in an exchangeable asset and can exchange or not exchange into new property as he or she pleases.
Advantage: Relatively convenient. There should be a "co-tenancy agreement" that contains provisions that mitigate the risk that the co-tenancy is treated as a new partnership. See Revenue Procedure 2002-22.
Disadvantage: Generally ineffective tax-wise if done after a contract of sale is entered into. There are due-on-sale implications for mortgage loans if the sale is not completed. The governance dynamic that was in the partnership agreement gives way to a less convenient co-tenancy arrangement. Also, there are theoretical investment intent problems since the taxpayer must hold property for investment in order to exchange and at the time that the exchanging partner receives his individual interest in the property from the partnership he intends to sell it (there is some authority that the partnership's prior intent to hold for investment should carry over).
Everyone exchanges within the partnership - the "swap and drop." If all partners wish to exchange, but into separate properties, the partnership can sell its old property and exchange into the several properties identified by the partners. After the exchange is "old and cold," the partnership can liquidate by distributing (generally tax-free) newly acquired property A to partner A, newly acquired property B to partner B, etc.
Advantage: No transfers of property or ownership interests out of the partnership occur prior to or during the exchange.
Disadvantage: Often difficult to manage. Unanticipated boot/gain may result from the one partner who commits to but fails to exchange. Identifications are made at the partnership level reducing the number of properties that can be identified under the "three property rule."
Pre-sale redemption of partners - The partner who does not wish to exchange can be redeemed out of the partnership in exchange for an undivided interest in the property. When the property is sold, there are two sellers: the partnership (whose remaining partners wish to exchange) and the non-exchanging redeemed partner. The redeemed partner takes his or her share of sales proceeds and pays the tax. The partnership takes its share of sales proceeds and exchanges. A variation on this approach is to redeem out the non-exchanging partner for a note secured by a second mortgage against the property. In this circumstance, the non-exchanging partner's share of sales proceeds is akin to a mortgage pay-off, reducing the amount of net proceeds to be exchanged (however, the partnership must still trade up or even on the full price of the property to completely defer gain).
Advantage: Isolates the non-exchanging partner and allows him or her to do as he or she pleases without adversely affecting other partners (except for possible due-on-sale implications).
Disadvantage: Once again, the time between the redemption and the sale is often short. A redemption after the contract of sale is entered into is of questionable validity. There are potential investment intent issues here as well. Compliance with the co-tenancy rules is required.
Post-exchange redemption of partners - Those partners who do not wish to exchange can be redeemed out of the partnership after the exchange. In order to completely avoid gain recognition, all proceeds from sale must be rolled over into new property, including the share of proceeds that would be received by the non-exchanging partner. In order to generate the cash necessary to redeem out the non-exchanging partner after closing, the new replacement property may be refinanced to produce the cash, but only after the closing. Alternatively, the exchanging partners could contribute new cash to the partnership to be used to redeem the non-exchanging partner.
Advantage: No transfers of property or ownership interests occur prior to or during the exchange. When properly structured, this approach has a relatively low level of tax risk.
Disadvantage: The second financing cannot be prearranged. To avoid gain, the exchanging partners end up acquiring a larger property than they might otherwise intend. The new property is acquired in an entity that may have some residual liabilities associated with the old property.
Election out of Subchapter K - For raw land or net leased property, a partnership may make a special tax election (retroactive to the beginning of the taxable year) not to be treated as a partnership for tax purposes. All partners must consent. The partnership remains the legal owner of the property. However, for income tax purposes, the partnership does not exist. Therefore, when the partnership sells its property, for income tax purposes, each partner is treated as an individual seller of property. Each partner can exchange or not exchange into new property as he or she pleases.
Advantage: The property does not have to be deeded out of the partnership. Making the election is a straight-forward process if the partnership qualifies (amendments have to be made to the partnership agreement to conform to the special tax status of the partnership). Code Section 1031 itself contemplates the possibility of an election out of Subchapter K, implying relative safety in this approach; however, Revenue Procedure 2002-22 does not sanction it.
Disadvantage: Technically the election is not available unless the property is raw land or net leased. The Internal Revenue Service has not yet ruled in situations where the election is made for the first time in the year in which the property is sold. The Service has also questioned whether a valid election out of Subchapter K can be made by an LLC or limited partnership. An election made after a contract of sale is entered into is of questionable validity.
There are numerous variations of these approaches. Depending upon the particular circumstances (the number of people exchanging versus not exchanging, the taxpayer's tolerance for risk, the time remaining before sale, etc.), one approach will be more suitable than another, and your attorney should be consulted about the proper method.
The analysis ultimately has to be made whether the transactional costs, complexity and risk associated with structuring to take advantage of Section 1031 in these circumstances are worth the potential tax deferral from accomplishing the exchange. With adequate time for planning, the answer should be yes. The practical reality is that much partnership restructuring occurs on the eve of the sale, leading to an uncertain result.