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, that entity is viewed as the exchanging entity.

A common question posed to our firm involves situations where the property is being sold, but one or more of the partners wishes to take their share of the cash and pay the tax, while the rest of the partners want to stay in real estate and desire to do a 1031 exchange. Let's use the FGH Partnership as an example where F, G, and H each own an equal one-third interest in the partnership. The partnership has entered into a Purchase and Sale contract to sell the Old Property. F and G wish to stay in real estate and have decided they want to do a 1031 exchange. H, however, has decided that it's time to cash out and wants his share of the cash.

Under most partnership agreements F, G, and H share equally in the profits and losses generated by the partnership. This means that if F, G, and H each put in $100,000 to buy the Old Property for $300,000, and have now contracted to sell it for $900,000, they have a realized gain of $600,000. In a simple world, H should be able to take his share of the sale ($300,000) and pay tax on his $200,000 gain. Unfortunately, the 1031 exchange rules make it more complicated than that.

...This type of problem is not insurmountable if you work with a top-notch intermediary...

Let's say for the moment that F, G, and H decide to hold $300,000 out of the transaction to buy out H, with the remaining $600,000 going to their qualified intermediary to be used for the purchase of F and G's New Property. However, the 1031 rules require that cash taken out of an exchange is taxable. The rule states if the amount of the cash taken out ($300,000) is smaller than the realized gain ($600,000), the entire amount taken out ($300,000) must be treated as a taxable gain to the partnership. Under the partnership agreement, each partner would be allocated $100,000 of the tax consequence of the gain. F and G would each pay tax on $100,000 even though H has gotten all the cash. Obviously, F and G would not be happy with the outcome, but H would think this arrangement is pretty cool.

However, if the FGH Partnership amended the partnership agreement to provide for specific allocation of the gain to H, the result would be that the entire $300,000 is taxable to H even though his share of the gain is really only $200,000. H would not be happy with this amendment because he would have to pay taxes on $50,000 that had been allocated to F and on another $50,000 that had been allocated to G.

H's dissatisfaction with this arrangement notwithstanding, this approach is problematic. The typical scenario would be that FGH's attorney dissolve the partnership and give F, G, and H each an undivided one-third tenant-in-common interest in the Old Property. This is usually done a week or two before the sale (if that far ahead). The plan would be that F and G would each do an exchange with their combined shares and would take ownership in their own names. H would receive $300,000 cash, of which only the $200,000 in excess of his basis of $100,000 would be taxable. The chances would be great, however, that upon audit of the exchange, an IRS agent would claim the FGH Partnership was the selling entity since that was who contracted for the sale. The entire exchange would fail since the FGH Partnership had not taken title to the replacement New Property.

The solution to the problem would be to "drop" H out of the partnership. This could be done by giving H a quitclaim deed for an undivided one-third interest in the property in exchange for his partnership interest. The result would be that there would be two owners to the property: the pre-existing partnership that would still own an undivided two-third's interest, and H who would own an undivided one-third interest.

At the closing of the sale, H would receive a check for $300,000 and he alone would owe tax on the realized gain of $200,000.

From the partnership's standpoint, it could do an exchange on the new partnership's share of the proceeds of $600,000. The fact that H has left the partnership would not be a problem for the exchange, provided that the cumulative change in ownership did not equal 50% or more (the change in this example would be only 33%). If the change reached the 50% level a technical liquidation of the partnership would occur and the exchange could be disallowed.

This type of problem is common but is not insurmountable. The more time you give your intermediary to coordinate the details, the easier it will be. Just make sure you work with a top-notch intermediary.