When accountants learn that 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 these 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 which can arise with partnership 1031 exchange transactions.
In this post, we will introduce a few of the most common issues which come up when partnership entities conduct 1031 exchanges. We will also discuss the kind of guidance which may be potentially useful for clients when such issues develop. Obviously, CPAs should not be expected to counsel 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 which may follow in a given situation. Let’s go through each issue in turn.
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 which sells real estate must also be the entity which acquires real estate; in other words, there must be consistency of ownership across the entire period of the exchange. The entity which sells must also be the entity which satisfies all of the requirements of 1031 as established by statutory law 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, then the traditional guidance is to dissolve the partnership and convert the partnership interests into “tenants-in-common” (or “TIC”) interests so that the relinquished property can be sold and then the members who wish to proceed with the exchange can proceed and the exiting member (or members) can go their own way.
Let’s look at an example: suppose a partnership is comprised of three members and two of the members wish to conduct an exchange, but the other remaining member simply wishes 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 owns exactly one third.