Counseling Partnerships in a Section 1031 Exchange
When accountants learn one of their clients is preparing to conduct a tax-deferred exchange under Section 1031 of the IRC, few are in a position to give any kind of useful counsel.
In these situations, usually, CPAs can point their clients in the direction of a qualified intermediary or tax attorney, but seldom can they identify potential issues or provide basic information on Section 1031 mechanics. This is particularly true with regard to partnerships.
These entities frequently perform 1031 exchanges, and the transactions tend to have their own unique issues and concerns. CPAs can improve their practice substantially by providing at least minimal levels of counsel on the various tax issues that can arise with partnership 1031 exchange transactions.
Obviously, CPAs should not be expected to advise their clients on every nuance of these issues, but they can at least offer some preliminary feedback and give guidance as to the most probable tax consequences that may follow in a given situation. Let’s go through each issue in turn.
1031 Exchanges: Drop & Swap or Swap & Drop
Whenever a regarded partnership conducts a 1031 exchange – that is, a partnership which files its own tax returns and is considered a separate entity from its members – that partnership will always face a critical question: Will the entity be performing the exchange, or will it be dissolved prior to the exchange and have its partnership interests be converted to interests in real estate?
For a 1031 transaction to be valid, the same entity that sells real estate must also be that which acquires it; in other words, there must be consistency of ownership across the entire period of the exchange. The seller must also satisfy all of the requirements of the 1031 as established by statutory and common law.
This is where the strategies known as "drop and swap" and “swap and drop” come into play. If a partnership consists of members who do not all wish to conduct the exchange, the traditional guidance is to dissolve the partnership and convert its interests into “tenants-in-common” (or “TIC”) ones so the relinquished property can be sold. The members who wish to proceed can do so and the exiting one (or ones) can go their own way.
Let’s look at an example: Suppose a partnership is comprised of three members, two of whom wish to conduct an exchange. The other, however, simply wants to cash out and exit the partnership. For simplicity’s sake, let’s suppose that the LLC owns real estate worth $300,000, and each member possesses exactly one-third.
In this hypothetical example, the partnership would need to “drop” the LLC into three distinct TIC interests that correspond to the ownership interests in the LLC. Then, when the real estate is eventually sold, the departing member would simply sell his/her TIC interest without an exchange contract, take the cash and pay taxes to the extent of the gain. The other two members would sell their TIC interests in an exchange and either buy separate replacement properties or work together to purchase a common one.
This is a very, very rudimentary example of a “drop and swap” exchange. In the swap and drop variation, this process is reversed. So, the partnership entity would conduct the exchange at the entity level. Then, the members would later drop the LLC into TIC interests so the exiting party could leave.
Between these two variations, the first (drop and swap) variation is the more common. This is because the other requires agreement between all partners participating in the exchange as to which replacement property they wish to acquire. It also necessitates cooperation from the exiting member, as they have to wait until all boxes are checked off in the exchange before they can cash out and leave.
In both of these variations, the key requirement that is potentially at issue is the holding requierment, one of the four main elements of Section 1031. It states that both the relinquished and replacement properties must be “held for” investment or business purposes by the owning entity.
If a partnership owns a property and drops into TIC interests prior to the sale, we can see how such a maneuver might trigger scrutiny of the holding requirement: Were the members possessing the TIC interests holding the property for investment or business purposes, or for sale? Remember, the entity that sells must be the entity that acquires. If the partnership is converted into TICs, then the members holding them must satisfy the 1031 requirements, not the original partnership.
Likewise, if the partnership is dissolved after the exchange in a swap and drop, then it must also satisfy the holding requirement with respect to the replacement property before converting to TIC interests. Again, it would be unreasonable for clients to expect their CPA to have expert guidance on more advanced scenarios, but those accounting professionals who can at least give introductory counsel will go far in distinguishing their practice from others.
If a given 1031 transactions doesn’t satisfy the holding requirement, the entire exchange can fail. This would mean your client will suddenly be slapped with capital gain taxes, penalties and interest to the IRS. If you can advise your customers on the mechanics, issues and potential consequences of these exchange strategies, you will be doing a lot to stand out from the crowd.
Exit Strategies: Partnership Installment Note Method
This is where CPAs can go a step even further and really help their clients.
If you come across a partnership client considering an exchange, you may want to discuss the so-called “partnership installment note” (“PIN”) method as one possible way of structuring the transaction.
These are basically variations on the swap and drop described above: Instead of staying in the exchange until after the replacement property is acquired, the exiting member (or members) receives a note for an amount consistent with their ownership stake in the LLC when the relinquished property is sold.
The exiting member receives this note directly from the buyer. It functions as compensation for leaving the entity and also allows the other remaining members to avoid recognizing any gain when payments on the note are made.
Let’s look at a hypothetical case of a PIN transaction.
A three-member LLC owns a property worth $300,000, and each member owns one-third. Instead of participating in the exchange, the exiting member leaves before the sale and receives a note that entitles them to one-third of the proceeds.
So, when the buyer obtains the property, he/she only transfers $200,000 to the entity. The other $100,000 is gradually transferred to the exiting member over time. If this amount were to be placed in the exchange, it may be subject to more taxation when it is received as “boot” by the entity and then paid out to the exiting member.
Hence, the PIN method avoids excessive taxation and also simplifies the process by keeping the LLC intact throughout the entire transaction on both ends.
Telling your clients about this and other strategies will help you stand out from the crowd and build a base of satisfied, loyal customers.
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Jorgen Rex Olson is a graduate of Washington State (B.A., cum laude, 2008) and the Indiana University (McKinney) School of Law (J.D., 2012). He writes for Mackay, Caswell & Callahan, P.C., one of the leading tax law firms in New York State.