Our thanks to First American Exchange, Co for the information contained in this article.
When a partnership is selling property and some of the partners want to cash out and others want to reinvest, it can create complications with a 1031 exchange. There are a couple of reasons for this. First, under IRC § 1031(a)(2) (D), partnership interests are not exchangeable. Second, the taxpayer that sold the relinquished property must acquire the replacement property. For example, if a partnership sells the relinquished property, that same partnership must buy the replacement property. If individual partners buy the replacement property, it will not be a valid exchange.
A common solution to this problem is to dissolve the partnership prior to the sale and distribute tenant in common interests in the property to the individual partners (this is the “drop”). Those individual owners then deed the property to the buyer. Some former partners exchange their interests (here’s the “swap”) into replacement property, and others take the cash proceeds and pay tax on the gain.
While a drop and swap is a common structure, it is not without tax risk. In order to qualify for 1031 treatment, the property sold and the property purchased must have been “held for investment.” Although the code does not include a specific minimum time frame for which property must be held, if property is acquired by the individual partners immediately prior to the sale, the IRS may take the position that the individual partners acquired the property not for investment purposes, but rather for the sole purpose of selling it. Even if the original owner, the partnership, had owned the property for many years prior to the drop and swap, the individual partners may not be able to benefit from the partnership’s prior holding period.
Courts, however, have often interpreted the holding requirement more liberally and have permitted non-recognition of gain, even when there is a transfer immediately before or after an exchange from or to an entity controlled by the taxpayer. See Magneson v. Commissioner of Internal Revenue; Bolker v. Commissioner of Internal Revenue.
In addition to some favorable case law, the IRS decided in favor of the taxpayer in Private Letter Rulings 200521002 and 200651030. Both Private Letter Rulings addressed a testamentary trust that owned real estate and regularly did 1031 exchanges. The trust was due to terminate at a certain time and, per the trust’s termination plan, the assets of the trust would eventually be held in an LLC. The trust was expected to terminate during the exchange period in two of its transactions and immediately after the completion of a 1031 exchange in a third transaction. In each ruling, the IRS held that the termination of the trust and subsequent transfer of the properties to the LLC would not ruin the 1031 exchange transactions.
Moreover, there are other methods by which the IRS may challenge a drop and swap transaction. For example, partners who drop down to TIC owners but continue to operate as a partnership for their profit and loss allocations or for their purchase agreement negotiations may have a hard time arguing that individuals really dropped out of the partnership. In this situation, the IRS would likely find that the substance of the transaction occurred at the partnership level, rather than the individual level. See Chase v. Commissioner of Internal Revenue.
Within the last few years, the taxing authorities have started to pay attention to drop and swap transaction. For example, in late 2007, the California Franchise Tax Board (“FTB”) issued a notice with regard to its examination of like kind exchanges involving TIC interests. The notice indicated that the FTB would be examining whether TIC interests were actually disguised partnership interests. Although taxpayers have been relying on Revenue Procedure 2002-22 to structure their TIC transactions, the FTB stated that the conditions set forth in the Revenue Procedure would be considered minimum requirements for determining the existence of a TIC interest in rental real estate. This notice serves to remind investors that a TIC interest may be characterized as a partnership interest if the transaction is not structured properly. Since the partnership interests are not exchangeable, this can ruin an exchange.
Additionally, beginning in 2008, Partnership Income Tax Returns included two new questions in Schedule B portion of form 1065.
“…during the current or prior tax year, the partnership distributed any property received in a like-kind exchange or contributed such property to another entity (other than entities wholly-owned by the partnership throughout the tax year)”
“At any time during the tax year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property?”
The addition of these questions is a clear indication that the IRS is starting to track drop and swap transactions.
A drop and swap is a complicated transaction with a variety of tax implications. Below are some practical tips; however, investors should work closely with their CPA or attorney and analyze all of the tax issues involved with their specific transaction.
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