– What to do when some partners want to do a 1031 exchange, but others don’t –
A frequent call to our company goes like this:
“Five of us own an LLC. The LLC, in turn, owns a piece of real estate held for investment. It has a substantial gain in the property and we have the property under contract for sale.
Some of us would like to 1031x out of our investment, while others of us want to cash out.
How do we proceed?”
This tax question does NOT have a simple risk-free answer. That said, we can suggest strategies to maximize tax savings and/or minimize tax risk.
Why use an LLC or partnership for real estate investing?
Investment real estate is commonly owned inside of a limited liability company (LLC) with several members (owners). For tax purposes, these LLCs usually report income and expenses as partnerships (therefore as pass-through entities).
Traditionally, LLCs are the entity of choice for real estate ownership. This is because (1) of their liability limiting effect; (2) lenders prefer one bankruptcy remote entity on title; and (3) operating agreement can efficiently control management of the enterprise.
Not all jointly owned properties operate as a partnership. Indeed, many of our clients own property with co-investors but hold title as separate undivided interests (tenants-in-common, or “TIC”).
IMPORTANT: These are not considered partnerships for tax purposes and do not run into the same challenges from a 1031 perspective.
Potential Conflicts with Partnerships in a 1031 Exchange
Unfortunately, the IRS makes it challenging for real estate investors in a partnership to go their separate ways. Specifically, the regulations prohibit 1031 exchanges involving the purchase or sale of partnership interests. [See IRC Section 1031(a)(2)(D)]
Why? The IRS argues that partnership interests qualify as “personal property” and not “real property” — therefore not a like-kind investment in a 1031x.
The 1031 “drop and swap”
The easiest strategy to follow a “drop and swap.” In this strategy, the investors transfer the relinquished property out of the LLC structure. Use deeds of transfer to each respective member (owner), as tenants-in-common, of the LLC, pro rata, according to their LLC percentage ownership.
Next, amend the sale contract such that there are now multiple sellers instead of the original LLC. The LLC files a final tax return, mid-year, and then dissolves.
Transferring the property from the LLC and to the members should be tax-free under IRC section 731. Now, each former member sells their undivided interest in the property and decides whether or not to perform a 1031x.
This “drop and swap” strategy is — by far — the most common one when dealing with an LLC selling investment real estate where some members want to 1031x and some do not.
– A warning to California exchangers
CAUTION: while the IRS seemingly takes a lenient position on drop and swap transactions, the California Franchise Tax Board does NOT. California does NOT recognize drop and swap transactions and will impose California State income tax on any drop and swap out of California property.
Other exchange strategies for partnerships in a 1031 exchange
Many other permutations and complications involving partnerships and 1031x transactions arise or can be conceived. Here are a few common alternatives.
– Keep LLC intact; deed out only to non-exchanging members
Starting with the original question, we first ask how many members want to stay together as a group. If several members want to re-invest together, we may suggest a slightly different strategy (with less tax risk!). The LLC only deeds out to those members that want to cash out and not 1031x. The remaining members stay together. The LLC performs a 1031x and the resigning members, now tenants-in-common, are paid at closing and pay tax on their gains.
With this option, you keep the LLC alive and do not have a “drop and swap” transaction. The investment intent of the LLC continues. This strategy should also satisfy the State of California.
– Exchange together, refinance and cash out
It is possible for all members in the partnership to stay within the LLC structure and sell together. They would need to remain together until the purchase of the replacement property. Once the exchange is complete, they would refinance the replacement property and distribute the proceeds to those partners who originally did not want to 1031x.
While seemingly attractive, this option comes with challenges. First, exchanging the entire relinquished property means it will be more difficult to trade equal or up in value. Second, this option means that members not wishing to 1031x will wait longer for their proceeds. Finally, the IRS may look unfavorably on a quick refinance of the replacement property if it believes the sole purpose of the refinance was to take cash out without paying taxes.
Always feel free to contact us with your brain teaser. The consultation is always free.
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