50% Partnership Interest Purchase: ‘OK’ says IRS in a Reverse Exchange

One of the provisions of Section 1031 is a prohibition against buying a partnership interest as the replacement property in a 1031 exchange. This provision assumes that you’re buying the actual partnership “shares” as your replacement property. This makes sense if you think about it since partnership interests are not real estate, (they’re an intangible – like stocks or bonds), even if the partnership-owned asset IS real estate.

As with most things in IRS-land there are exceptions, and the IRS has just carved out such an exception with a private letter ruling issued last month. In PLR 200909008 the IRS ruled that the taxpayer could acquire a 50% partnership interest in a reverse exchange and then subsequently take over that interest to complete their exchange.

...As with most things in IRS-land there are exceptions, like this one issued last month...

While on the surface it would seem that this ruling contradicts the language in the code section, if you work through their logic this ruling makes sense. But I have to wonder why the taxpayer structured it this way.

The partnership had two partners: A and B. B wanted to sell his 50% interest to A. Since A already owned the other 50%, when he acquired the interest and the transaction was completed, he would own all of the partnership.

A had not yet sold his old property. His plan was to sell his old property and then buy B’s 50% interest in the partnership by doing a 1031 exchange, so he requested a ruling on whether he could buy the partnership’s real estate by buying B’s partnership interest. He also wanted to know whether he could put his plan into motion early by doing a reverse exchange and having his intermediary buy B’s partnership interest.

IRS rules do not allow taxpayers to do 1031 exchanges when they acquire the new property before they’ve closed the sale of the old property. A structure called a “reverse exchange” gets around this by having the taxpayer’s qualified intermediary buy the new property and hold it, or park it, until the old property is sold. In this case, the 1031 intermediary would take title to B’s partnership interest and hold it until A sold the old property.

The IRS approved the request because after A sells his old property and exchanges into the partnership interest held by his intermediary, his ownership of the partnership would be 100%, making him the only owner of the partnership. Since there is no such thing as a one-partner-partnership, the partnership would automatically dissolve and A would be the sole owner of the real estate, thereby meeting the test of selling real estate and then buying real estate to complete his exchange.

As is frequently the case with these types of rulings, they raise more questions for me than answers. A private letter ruling is an answer, if you will, to the taxpayer’s question. Since the IRS does not release the original request from the taxpayer and typically only gives us enough taxpayer information to justify their ruling, we have to guess at the unstated facts.

I’m curious as to why the transaction was structured this way rather than simply dissolving the partnership into A and B’s tenant-in-common ownership of the real estate, with A acquiring B’s interest when A’s old property sale closed. A different IRS code section (Section 708(b)(1)(A)) terminates a partnership anytime there is a change of a 50% or more interest in the partnership in a 12 month period. Obviously there was de-facto liquidation here anyway, so why not structure the transaction that way from the beginning and skip the need for IRS approval? Reading between the lines, A must have wanted the partnership to stay in existence, but I don’t see how that was possible. The IRS ignores the de-facto liquidation required by Section 708, but doesn’t say why.

The transaction was approved by the IRS as a “safe harbor” reverse exchange which required A to sell his old property and complete the exchange within 180 days of the intermediary acquiring B’s interest. Apparently A intended to do a “safe harbor” (rather than a “non-safe harbor”) reverse, but I’m left to wonder if a non-safe harbor transaction would have had an impact on the IRS approval of A’s request. (Non-safe harbor reverse exchanges have a much longer time frame).

I’m also curious as to why it was necessary for A to buy B’s share now rather than in a few months. Why not skip the reverse exchange process, leave B in place until A’s old property sold and then buy out B? That would satisfy and complete the 1031 exchange. The IRS had previously ruled that buying the remainder of your partnership’s interests as replacement property satisfies the requirements of a 1031 exchange since you end up owning 100% of the partnership which triggers it’s liquidation.

In the end, this is a logical ruling and I agree with it. But I just don’t understand why they went out of their way to make a simple transaction complicated.