1031 Exchanges and Partnership Challenges

Partnerships holding real estate investments face major challenges when some partners want to do a 1031 exchange while others want to cash out at the sale. But there are a number of options that can allow all the partners to get what they want. Timing and planning are required to meet both the IRS partnership and 1031 exchange rules. Here are just a few of those strategies:

1. The Drop and Swap Method. Real estate investment partnerships can be distributed to the partners as a separate “tenancy in common interest,” and the partnership entity is dissolved. Property is then held for at least a year prior to the sale and each tenant in common owner can either cash out or participate in individual 1031 exchanges. There are stringent IRS tenant in common ownership requirements that must be met per Revenue Proc 2002-22, including annual management agreements.

2. The Swap and Drop Method. Like above, but rearranged. This method works if all the partners want to do a 1031 exchange, and the sale of the old investment property is imminent. The partnership entity enters into a 1031 exchange and purchases a designated replacement property for each partner. After holding the replacement property for over a year after the purchase date, the partnership is dissolved and each partner receives ownership of their designated property as a distribution.

3. Cash Out Partner Prior To or After a 1031 Exchange. The partners who want to keep the partnership entity alive and intend to stay together to do a future 1031 exchange will purchase the partnership interests of the partners who want to cash out prior to any 1031 exchange sale. They can also have new partners buy out the cashing-out partners either before or after a 1031 exchange.

4. Drop Out Exiting Partners at Closing. If the partnership agreement allows for special allocations, the exiting partner’s interests are distributed by a tenant in common deed immediately before or during the closing. Consequently, the exiting partners immediately receive their cash distributions. 

With the Tax Cuts and Jobs Act of 2017, a partnership does not have to dissolve if more than 50% of the partners leave. Prior to the Tax Act, a partnership was required to dissolve. It was not optional. But since its passage, a partnership losing over 50% of its partners can remain in existence if two or more original partners stay in, and the partnership can do a 1031 exchange. Special allocations are fairly tricky, and partnerships may need time to review agreements and contracts. Additionally, the partnership needs proper legal and tax advice to meet the IRS requirements and reporting for the partner changes.

5. Division of Partnerships. Code Section 706(b)(2) provides special rules for mergers and divisions of partnerships that do not result in their terminations. A partnership can be divided into multiple partnerships so long as one or more of the resulting partnerships have at least two partners who owned more than 50% in the capital and profits of the prior partnership. For example, a two-person partnership could divide their current situation into two partnerships, each owning a 99% interest in one and a 1% interest in the other of their respective partnerships. Each partnership would participate in a 1031 exchange and acquire replacement property. After a year or two, the majority partner would buy out the minority partner and become the sole owner of the property. At that time the multiple partnerships would be dissolved if there’s only one partner remaining.

6. Partnership Installment Note Transaction. This is a more complicated transaction to arrange, but it can be done with a competent and knowledgeable attorney and tax advisors. First, the property sales contract is amended to reflect an installment note that matches the partnership interest of the cashing-out partner. The partnership entity is not taxed because no cash has been received when they move forward with a 1031 exchange. The installment note is transferred to and held by the cash-out partner as redemption of their partnership interest. The first installment payment is generally a majority principal payment to be paid to the exiting partner, and a residual payment would need to be received when the new tax year begins. 

1031 exchanges with partnerships can be a challenge when you have wayward partners with conflicting goals. But with the options listed above, many partnerships can be successful in structuring safe 1031 exchanges. Utilizing an experienced Qualified Intermediary, like the 1031 Exchange Experts who understand partnership entities and 1031 exchanges, will benefit partners pursuing their best options involving partnerships and 1031 exchanges.

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