More Partnership and LLC Issues In 1031 Exchanges

One of the requirements of a 1031 exchange is that the entity that sells the Old Property must be the same entity that acquires the New Property. Where the property is owned by a partnership or a limited liability corporation (LLC) with multiple partners, the partnership or LLC is viewed as the exchanging entity.

A common question posed to our firm involves sales of property where each of the partners wants to do an exchange, but all of them no longer want to be partners with each other. Let's take as an example the FGH Partnership in which Fred, George, and Howie each owned an equal one-third interest in the partnership. This partnership had entered into a Purchase and Sale contract to sell the Old Property. Fred, George, and Howie wished to stay invested in real estate and decided they wanted to do a 1031 exchange, but all three partners chose to go in a different direction. How could a 1031 exchange have been completed if the partnership was required to do the exchange as an entity?

The solution that most attorneys would have adopted at this point is to dissolve the partnership (the partnership goes out of existence) and in return for their investment in the partnership, each partner in this example would have received an undivided, one-third, tenant-in-common interest in the property. Now three tax returns (Fred's, George's, and Howie's) represent ownership of the property, and when the sale closes each partner can do an exchange and go their separate direction--at least in theory.

The problem with this structure is that it violates the primary rule of 1031 exchanges that requires the exchange property be held as an investment, rather than held for resale. Typically this stipulation results in the need for a holding period of at least a year and a day. When the partners' attorney transfers ownership from the partnership to each of them, he starts their year and a day holding period over again. Thus, if any of the partners get audited, the IRS most likely will argue that they have not owned their property for investment, but for resale since their holding period starts over when the taxpayer owning the property changes from the partnership to each partner.

...probably the best solution is to sell the Old Property and purchase three New Properties — one for each partner...

So, how do we solve this problem? There are several solutions, but probably the best is to leave the partnership intact and have the partnership sell the Old Property and purchase three New Properties--one for each partner. The partnership would then hold all three New Properties for at least a year and a day, at which point their attorney could then dissolve the partnership and distribute the three New Properties to the individual partners.

Let's say, as an example, that the partnership is selling the Old Property for $300,000. The partnership must be intact for this transaction to occur. The solution could be as follows: Fred would find New Property #1 worth $100,000 to be purchased by the partnership. George would find New Property #2 and Howie would find New Property #3, each also costing approximately $100,000. All three New Properties would be purchased by the partnership as replacement property. So, in summary, the transaction would be structured as a 1031 exchange with the partnership selling one Old Property for $300,000 and buying three replacement New Properties totaling at least $300,000.

There are, to be sure, still a few small problems with this structure. Probably, the most problematic is the handling of debt on the three New Properties. Since the partners would buy the three New Properties with the intention of eventually dissolving the partnership and distributing the properties out, they would not want interlocking loans on the three properties. Interlocking loans would mean that each partner is still partially responsible for the loans on the other two properties after the three properties are distributed. The best way to solve this problem would be to use the same lender on each New Property and to get the lender involved in the plan from the beginning so that at the dissolution of the partnership the loan guaranties may be dropped on each of the two properties owned by the partners not ending up with the property.

Another common problem with the structure is that during the year and a day of common ownership of the New Properties, it offers no means for individual partners to receive the cash flow from their property. An easy way to ensure that cash flow is received is to appoint each partner as the manager of their target property and to set the compensation for this position as the cash flow from that property.