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‘Swap ‘Til You Drop’ – Partnership Exchanges

Date

May 1, 2002

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10 minutes

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In order to have a valid like-kind exchange involving real estate under Section 1031 of the Internal Revenue Code, a taxpayer must exchange an interest in real estate (which in Illinois, includes an interest in a land trust) for another interest in real estate. Exchanges of partnership interests (even if the partnership owns nothing but real estate) are not valid exchanges. The comments below are pertinent to multi-member limited liability companies as well as partnerships.

When real estate is held by a partnership, one of two things usually occurs:

  1. All of the partners want to sell the partnership property and re-invest proceeds into the same new property. In that case, the partnership is the ""taxpayer"" and makes the exchange itself.
  2. The partners want to sell the partnership property, but each partner wants to do with his share of the proceeds as he pleases. One may want to exchange into new property. The other may want to take his share of the sales proceeds in cash and pay his taxes.

In the latter situation, attorneys are often asked to advise on a structure for accommodating divergent interests. There are a variety of ways to do this, none of which is free from risk. The greatest risk in each case is attributable to the fact that this sort of planning usually occurs shortly before the sale, since the partners will rarely anticipate the complexities and rarely seek advice early enough.

The paragraphs which follow briefly summarize the several techniques that are sometimes used to accommodate partnership sales when not all of the partners intend to exchange into the same property. Readers of this article should also review the author's article on Revenue Procedure 2002-22, which sets forth Internal Revenue Service guidelines for the co-ownership of real estate.

 

A. Pre-Sale Liquidation of the Partnership. 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 real estate and can exchange or not exchange into new property as he 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 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. 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).

 

B. Pre-Sale Redemption of Partners. Rather than liquidate the partnership, 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 share of sales proceeds and pays his tax. The partnership takes its share of sales proceeds and exchanges. This approach is preferable to redeeming out the partner who wishes to exchange, although which group (exchanging or non-exchanging) stays in will often be driven by non-tax considerations. Another variation (where the partnership is averse to deeding out a fractional interest in the property) 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 to do as he 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.

 

C. 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. This will include 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 (this could be by line of credit, second mortgage or a complete refinancing of the acquisition loan). 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.

 

D. External Buy-Out. Those partners who wish to exchange may buy out the non-exchanging partner before or after the exchange for the amount of cash that the non-exchanging partner would have netted from the sale. In either case, it is necessary for the partnership to exchange all net proceeds of sale, which underscores the point that the buy-out must come from new funds provided by the exchanging partners and cannot be funded from the proceeds of sale.

  • Advantage: No transfer of property occurs prior to or during the exchange. The buy-out is external to the partnership and is readily documented. When properly structured, this approach has a relatively low level of tax risk.
  • Disadvantage: The exchanging partners must provide additional capital to buy out the non-exchanging partners. The exchange is being made with all of the proceeds of sale and not just the proceeds allocable to the exchanging partners, resulting in the acquisition of a larger property than might otherwise been intended. In order to avoid tax distortions, exchanging partners who are buying out the non-exchanging partner should consider having the partnership make a Code Section 754 election to step up the inside basis of the underlying property.

 

E. Everyone Exchanges within the Partnership. 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 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; in other words, the partnership can designate up to three properties – each partner does not get three.

 

F. Special Allocations. In certain situations the partnership can sell and exchange into new property using only the proceeds that belong to the partner who wishes to exchange. The remaining cash can be distributed to the non-exchanging partner in liquidation of the non-exchanging partner's interest in the partnership. Because not all cash is used to buy new property, there is usually some boot/gain. It is logical to specially allocate the boot/gain to the non-exchanging partner. However, the Internal Revenue Service may view this as a special allocation without substantial economic effect and reallocate the gain among all partners (exchanging and non-exchanging) in accordance with their percentage interests.

As a technical way of circumventing the substantial economic effect issue, the property may be sold partly for cash and partly for a short-term note. The cash portion will correspond to the exchanging partner's share of proceeds. The note which the partnership receives is given to the non-exchanging partner in liquidation of his interest in the partnership. The note comes due shortly after the closing, and when the note is collected by the non-exchanging partner the gain flows to the non-exchanging partner, by-passing the partnership and thus, arguably, by-passing the substantial economic effect issue.

  • Advantage: The special allocation requires a short amendment to the partnership agreement to provide for an allocation of any boot/gain to the non-exchanging partner.
  • Disadvantage: Avoiding the substantial economic effect issue requires structuring the sale as a part installment sale, which creates logistical difficulties in the form of security for the deferred payment. Other complications arise if there is substantial de-leveraging (there may be more boot/gain than it is fair to specially allocate).

 

G. 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 pleases.

  • Advantage: Real estate does not have to be transferred 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. An election made after a contract of sale is entered into is of questionable validity.

 

* * *

There are numerous variations of the above 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.

The analysis ultimately has to be made whether the complexity and risk are worth the while. Since exchanges have been relatively low audit risk transactions, many taxpayers take the view that there is much to gain and relatively little to lose. The ideal approach is to structure the acquisition of the property for the possibility that it will later be exchanged; in that connection, Revenue Procedure 2002-22 provides useful guidance.

 

© COPYRIGHT 2002. ALL RIGHTS RESERVED.

Circular 230 Disclaimer
In conformity with U.S. Treasury Department Circular 230 this document and any tax advice contained herein is not intended to be used, and cannot be used, for the purpose of avoiding penalties that maybe imposed under the Internal Revenue Code, nor may any such tax advice be used to promote, market or recommend to any person any transaction or matter that is the subject of this document. The intended recipients of this document are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this document.


Filed under: Tax Planning, Trusts & Estates

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