Overview

With property owned by a partnership/LLC, the following scenarios often occur:  some partners may want the partnership to stay together and do a 1031 exchange, others may want to do their own separate exchange with their portion of the property, and others may want to receive cash and pay the taxes owed.

However, it is important to note that the partnership owns the real estate capital asset and is the taxpayer entitled to conduct an exchange.  The individual partners own partnership interests and don’t have an ownership interest in the capital asset owned by the partnership.  It is also important to note that partnership interests are specifically excluded from Section 1031 under section 1031(a)(2)(D).  Therefore, if less than the entire partnership wants to conduct an exchange, then, typically, one or more partners must convert their partnership interest into an interest in the real estate capital asset.

The Drop and Swap

In a “drop and swap” transaction, the partnership conveys a fractional interest to a subset of the partners

as tenants-in-common who then sell or exchange. Some of the risk factors from this are:

• The individuals who received their interest from the partnership may not meet the “held for investment” requirement of IRC section 1031 because the individuals received the property just prior to the exchange and for the sole purpose of selling it.
• Alternatively, transfers to all of the partners by the partnership could be construed as an asset sale followed by a partnership liquidation with the gain on the asset sale allocated to all of the partners.
• The series of transactions is deemed an exchange of a partnership interest prohibited under 1031(a)(2)(D).

The Swap and Drop

In a “swap and drop” transaction, the partnership exchanges into replacement property and immediately thereafter conveys a tenant-in-common interest to each partner. Here the risk is that the IRS could argue that the replacement property was never held by the partnership for investment because it held the property only briefly before distributing it to the partners.

Considerations

Generally speaking, the more time that passes between the “drop” and “swap” the better.

Also, be aware that IRS Form 1065 (Partnership Return) and IRS Form 8824 (for reporting Like Kind Exchanges) contain questions to identify improper “drop & swap” or “swap & drop” transactions.  Based on the information reported on these forms, some pundits recommend that it is better if the drop occurs in one tax year and the swap/exchange occurs in the next tax year.

Given the complexity associated with pre- or post- exchange distributions, you should consult with a tax advisor experienced in partnership distributions and 1031 exchanges, well in advance of any transaction, to ensure that you minimize your risks.