Multi-Ownership issues in 1031 exchanges?

You and your co-partners, Fred and Sue, have decided to sell the small apartment building that you boght a few years ago. You got it for a steal and you've got a nice profit in it. It's not been on the maket long and you now have a full price offer.
You've always assumed that when you sold this property the three of you would roll into the purchase of another property, but Fred just told you that he wants to take his share and buy a new pickup. Yikes – and now Sue isn’t she so sure that she wants to buy another property. You don’t want to cash out because you’re pretty sure that Uncle Sam will take all your gain in taxes. Maybe selling the building wasn’t such a great idea.

Fighting the panic, you pick up the phone and call us afraid that you have a total tax disaster on your hands. You were hoping that you could do a 1031 exchange and roll your gain over to the new property and you certainly don’t want to pay most of your gain in taxes.
My first question to you is about how the title reads on your apartment building? You call Fred and Sue “your partners,” but what does that mean? Are they partners in the sense that you have a partnership that owns the building and files a partnership tax return? Or do you hold title as tenants-in-common but consider yourselves partners in the sense that you make decisions together?

Section 1031 says that the taxpayer that owns the Old Property must be the one that takes title to the New Property and report the 1031 exchange on its tax return. In your case, if your apartment building is owned by a legal partnership or an LLC, you, Fred and Sue must decide as a group if you’re going to roll the whole gain over by doing an exchange, or if you’ll all cash out and pay your taxes.

On the other hand, if you hold title individually as tenants-in-common, then your three separate tax returns own the apartment building, and each tax return (meaning each of you) can decide if you want to take your share of the cash and pay the tax, or do an exchange on your share. What you do does not depend on what your partners do.

Bad news – after calling your CPA you’ve determined that in fact you do hold title as an LLC meaning that the LLC is the one that must do the exchange. You’ve tried to talk Fred into going along with you and Sue in rolling over the gain, but he’s already picked the options for his new pick-up and now he tells you that he’s also booked a cruise in anticipation of the money he’s getting from the sale. Sue’s figured what her tax would be if she took the cash and she’s appalled and is with you on wanting to roll over the gain. So you call me back: “can you and Sue do an exchange while letting Fred take his cash and pay his tax?”

First of all you can’t dis-solve the LLC, although this is a common suggestion from most attorneys. Section 1031 requires that the property you’re exchanging must be held for investment and not for resale. Although the terms are not defined by the code, court cases generally hold that you have to hold an investment for more than a year for it to meet the definition of held for investment. Dissolving the LLC and transferring ownership to tenants-in-common will start the one year holding period over, which will disallow your exchanges if you sell right away. The IRS calls it a drop and swap and it’s a big no-no.

However, could you drop Fred out of the LLC allowing you and Sue to roll your gains over? Remember: the taxpayer (the LLC in this case) has to stay intact, but the IRS will allow you to drop members out of it as long as more than half of the original ownership stays intact. If you drop Fred out of the LLC, you’ll still have two thirds of the original ownership, so you’re okay there.
After you drop Fred out, the ownership title of the apartment building will be an undivided two thirds owned by the LLC and an undivided one third owned by Fred. This means that a third of the proceeds will go to Fred and two thirds will go into the LLC’s 1031 exchange account.

What about Fred – how will this impact him? Well, there’s another IRS code section that says that if you’ve owned an interest in a partnership or an LLC, and that interest is converted into a tenant-in-common interest which you then sell and have to pay tax on, the holding period of your ownership of the partnership/LLC is added to your ownership of your tenant-in-common interest to determine if the gain is short-term capital gain or long-term capital gain. Long-term capital gains pay less tax.
The end result of this strategy is that Fred can buy his pickup and take his cruise, and you and Sue can roll your gain over in a 1031 Exchange.