Partnership Issues
Many real estate transactions involve partners and formal Partnerships that own the real estate. A partnership is a tax-paying entity, usually with two or more members/managers or owners, each typically receiving a K-1 to report distributions, earnings, and the like based upon their fractional partnership interests. If a Partnership wishes to sell a Real Property asset, the Partnership could qualify for an exchange on the property; however, the Partnership must be the purchaser of the new property. Problems often arise when a Partnership is selling an asset it owns, and the investment objectives of one or more of the different members vary, causing them to wish to go their separate ways
It is crucial to understand that addressing exchanges involving Partnerships and changing the ownership structure may require advanced planning to avoid risks associated with making changes too close to an exchange. In most cases, advanced planning can resolve many issues. Generally, it is recommended that two full tax cycles should expire after making a change in ownership of the Partnership to allow any exiting members to qualify for the "Held For" requirement to perform a 1031 Exchange. This period could be as short as:
The year the distribution to the member occurred and was reported, plus
The full tax year following the distribution
If it is a period shorter than this, it is recommended to have a conversation with your tax advisor for clarity.
Here is a sampling of possible solutions to Partnership issues, though this is not intended to be all-inclusive:
Distribution of an Undivided Interest
This is considered the least risky method to pay out partners from a Partnership; however, it does leave the partners receiving a distribution having to pay tax. This would be allowed as long as two partners remained in the Partnership, of which at least ONE was an original member, allowing the Partnership to survive after the sale and complete an exchange. In this situation, the partner wishing to receive a distribution of their undivided interests in the property held by the partnership and being sold would NOT be allowed to elect a 1031 Exchange because they received Partnership Interests, which are not Real Property and thus not qualified for 1031 Exchange treatment.
Liquidate Partnership and Distribute Tenancy-in-Common Interests
Another popular method to allow partners to go their separate ways would be to distribute tenancy-in-common interests in the Relinquished Property and dissolve the Partnership. It is advisable to perform this function as far in advance of the actual sale as possible and, if possible, prior to any contract for sale being agreed upon. Two tax cycles of time are suggested to allow the now separate owners time to qualify as "held for investment" to qualify for exchange treatment.
Drop and Swap & Swap and Drop
These transactions generally sound like the previous method of Liquidating the Partnership and dividing interests tenancy-in-common, only the partners perform the tenancy-in-common ownership change directly before or immediately following the sale of the Relinquished Property. This is considered very aggressive in nature and must be discussed with your tax advisors prior to electing this path.
Buying Out One of Your Partners
This strategy is used before or after a 1031 Exchange to purchase the interests of one of the other partners in a Partnership. The selling partner would not be eligible to elect a 1031 Exchange as they are selling Partnership interests and not Real Property. The remaining partner, for a 100% tax-deferred exchange, would be required to purchase a replacement property of the SAME VALUE of the sale, unlike the distribution method which reduced the replacement purchase amount by the value of the distributed partners.
Note: A partner may use a 1031 Exchange from another sale to acquire the interests in property held by the Partnership from another partner or other tenant-in-common owner; however, they should not sell that property for the recommended two tax cycles after the purchase of the partner's interests with the first exchange. Conversely, buying out another owner or partner with new cash would allow you to sell the property right away and be eligible to elect a 1031 Exchange on said property.
