What if Your Partner Wants Out?
Most partnership issues can be resolved with advanced planning. With the right plan, partnerships, including LLCs taxes as partnerships, can structure a tax-deferred exchange that aligns with the investment goals of all partners involved. But what happens when partners have differing objectives? This common scenario raises a vital question: “Can a valid exchange still take place if one or more partners want to exit or go in a different direction?” Absolutely! Let’s explore the possibilities.
Strategic Options for Partners:
What if a partner wants to be cashed out of the partnership? Although there are many structures, many practitioners believe that there is less risk of an exchange being disallowed on audit if the partners desiring to receive cash on the sale of the Relinquished Property (cash-out partners) receive a distribution of their partnership interest in the form of an undivided interest in the Relinquished Property prior to the closing of the sale of the Relinquished Property. Then, as long as there are at least two partners (one of which was a partner prior to the redemption), this leaves the partnership in existence to accomplish the IRC1031 exchange.
At the closing, the surviving partnership and each of the former partners convey their respective interests in the Relinquished Property, with the former partners receiving cash, and the Qualified Intermediary receiving the net proceeds due the partnership to enable the partnership to complete the exchange when it locates Replacement Property. Completing the redemption distribution of the cash-out partners using the undivided interest method as far in advance of the sale, and if possible, prior to the execution of the contract of sale for the Relinquished Property, is highly desirable.
Another possible solution is to liquidate the partnership prior to the exchange and distribute to each partner a tenancy-in common interest in the Relinquished Property. It is advisable to transfer ownership to the individual Exchangers as far in advance of the exchange as possible. If a distribution or dissolution occurs shortly prior to the exchange (or shortly after the exchange), the key issue is whether the Relinquished Property (or Replacement Property) was “held for productive use in a trade or business or for investment purposes.” This qualified use requirement must be met by the individual Exchanger (former partner) for the exchange to be valid and is problematic when the distribution occurs within close proximity of the sale or purchase transaction. Conversely, the qualified use issue can generally be avoided through the strategy of distributing an undivided interest to the cash-out partners only (prior to sale), without liquidation, allowing the partnership to survive and complete the exchange.
What if a partner wants to separate into another property but continue with a 1031 exchange? “Drop and Swap” transactions are when a Partnership distributes the Relinquished Property to the partners shortly before the exchange and “Swap and Drop” transactions are when the Partnership distributes the Replacement Property to the partners shortly after the exchange. These transactions are considered aggressive since under these structures, the partnership’s prior holding period is not attributed to the individual Exchanger (the distributee of the property) that is completing the exchange. Hence, the Exchanger may be considered to be acting on behalf of the partnership, and the sale and gain recognition will be attributed to the partnership. Accordingly, “Drop and Swap” and “Swap and Drop” transactions should only be considered with the guidance of a tax advisor and transacted well in advance of the sale of the Relinquished Property (preferably 2 years prior) or well after the exchange (preferably 2 years after). The use of DSTs with their flexible investment amounts and diversity of asset classes and geographic locations are ideal for a swap and drop strategy (see also b below).
If distributing an undivided interest of the partnership property or dissolving the partnership well in advance of the exchange is not possible, the partners who want to exchange may consider one of the following: purchase of the interest of a retiring partner; sale by the partnership of the Relinquished Property for cash and an installment note; or a partnership division.
- Purchase of the interest of a retiring partner: This technique can be implemented before or after an IRC 1031 exchange. If done before the exchange, the partners who want to exchange contribute additional equity which is used to buy out the retiring partner(s). The partnership (with fewer partners) then enters into an exchange. The partnership must acquire Replacement Property which has the same or greater value compared to the Relinquished Property to fully defer taxes. If the partner buy out occurs after the exchange, the partnership typically refinances the Replacement Property received in the exchange to generate the cash necessary to buy out the retiring partner(s). Please note that refinance is not an option with a DST investment.
- Sale of the Relinquished Property for cash and an installment note: This method involves having the buyer of the Relinquished Property pay with cash and an installment note; the cash is used by the partnership in the exchange and the retiring partner receives the installment note in redemption of his or her partnership interest. If at least one true payment is paid in the following tax year, it should be considered a valid installment note and receive installment sale treatment under I.R.C. §453. Most tax advisors suggest that at least 5% of the total payments of the note be made in the next tax year.
- Partnership division: This technique can be done before, after, and possibly during an exchange. Using the partnership division rules of I.R.C. §708(b)(2), a partnership can divide into two or more partnerships. If a new partnership contains partners, who together, owned more than 50% of the original partnership, it is deemed to be a continuation of the original partnership. Although there may be more than one “continuing partnership”, only the continuing partnership which has the greatest fair market value (net of liabilities) will continue to use the Employer Identification Number (EIN) of the original partnership. All other partnerships resulting from the division will obtain a new EIN. For example, let’s assume that a partnership is comprised of Peter and Paul (each owns a 50% interest) who no longer want to be partners; Peter wants to do a §1031 exchange but Paul wants to sell his interest and “cash out”. Peter-Paul Partnership would divide into two partnerships; Peter-Paul Partnership I (John owns a 99% interest and Jeff owns a 1% interest) and Peter-Paul Partnership II (Peter owns a 1% interest and Paul owns a 99% interest). Peter-Paul Partnership would transfer the partnership property 51% to Peter-Paul Partnership I and 49% to Peter-Paul Partnership II, as tenants in common. Upon sale of the Relinquished Property, 51% of the sale proceeds would go to a Qualified Intermediary for Peter-Paul Partnership I’s §1031 exchange and 49% of the proceeds would be distributed to the Peter-Paul Partnership II for further distribution to the individual partners. As a result, Peter has a 99% interest in the partnership which owns the Replacement Property (and which continues to use the original partnership’s EIN) and Paul has received 99% of the cash value of his interest in the original partnership. After one to two years, Peter could buy Paul’s interest in Peter-Paul Partnership I and complete the separation, provided their tax advisor was comfortable with that timing. Although partnership division may not be suitable for partners who want to immediately completely separate their holdings, it provides a way to achieve this over a period of time and still comply with the “held for” requirement of §1031.
- Purchase of multiple properties by partnership: Although some authority exists to apply partnership division to situations where both partners want to exchange (but into separate properties); some advisors are not comfortable having their clients do so because only one of the resulting partnerships is permitted to continue to use the original partnership’s EIN. They prefer that the partnership purchase multiple replacement properties. Applying this to our example, Peter-Paul Partnership would exchange into two Replacement Properties and amend the partnership agreement to disproportionately allocate the respective income and depreciation from the properties to Peter and Paul. Most advisors believe that at least 10% should be allocated to the minority partner. Accordingly, the Peter-Paul Partnership would buy Whiteacre and Blackacre. Peter would be allocated 90% of the income and depreciation of Whiteacre and Paul would be allocated 10%. The reverse would be applied to the allocation of income and depreciation relating to Blackacre. After a period of time determined by their tax advisor (and with no prearranged plan), Peter and Paul could dissolve the partnership distributing Whiteacre to Peter and Blackacre to Paul.
Don’t let partnership complexities hold you back from realizing the full potential of your investments. With strategic planning and expert guidance, you can navigate the fascinating world of 1031 exchanges and make your real estate dreams a reality. Consult with a knowledgeable tax advisor today to discover the best approach for your partnership’s unique situation and unlock new avenues for growth!