A partnership can do a 1031 Exchange. But it has significant limitations. We’ll explain how a partnership can do a 1031 Exchange and the rules.
It’s no news that taxes are a vital component of real estate investments. Yet, you can avoid capital gains by using a 1031 Exchange.
The 1031 tax-deferred exchange enables an investor to sell an investment property and purchase similar property while postponing paying capital gains tax. But 1031 Exchanges don’t work the same with a partnership.
For over three decades, partnership interest trades have been exempt from non-recognition treatment under IRC 1031. Even if both partnerships hold the same type of real estate, 1031 does not apply to an exchange of interests in a partnership.
However, a partnership may exchange real property under Section 1031 if it complies with the conditions that apply to all exchange transactions. But before we go further, you must know what a 1031 Exchange is.
What is A 1031 Exchange?
Simply put, a 1031 Exchange is a trade-in of one investment property for another. Many often refer to it as a like-kind exchange or a Starker exchange. Most swaps are taxable, but if yours complies with 1031 regulations, you may only have a small amount of tax owed at the time of the exchange.
The cost of the replacement property, which can be of a like-kind or higher value, must match the actual property’s price for this to be effective. The kind or grade of property is irrelevant but like-kind properties must have the same characteristics.
It is impossible to qualify for a 1031 Exchange without an actual property. As a result, investment options like inventories, securities, or stocks and bonds, are not acceptable.
You have 45 days from selling the original property to find a replacement property and close the transaction within 180 days to conduct a 1031 Exchange effectively. Furthermore, you must buy the new property with all of the sale’s earnings. Any portion of the transaction that goes to another use gets taxed.
How A 1031 Exchange Works In A Partnership
The partnership owns every investment in a real estate partnership rather than the individual partners. Individual partners only own interests, which are each partner’s personal property.
Due to this, a partnership typically doesn’t qualify for a 1031 Exchange. The individual or group selling the property must be the same ones acquiring ownership of the new property, according to IRS regulations governing a 1031 Exchange.
As a result, when a partnership or LLC buys and sells real estate, the partnership or LLC must execute the exchange. Individual partners cannot complete a personal 1031 Exchange.
However, many options can make it possible for partners to accomplish a 1031 Exchange.
1031 Exchange Calculator
You can calculate your proposed sale and purchase’s tax implications using the 1031 Exchange calculator. Performing a 1031 Exchange requires you to use the money from the relinquished property. Your purchase must match what you sell to avoid paying taxes. A recognized gain is subject to taxation if you withdraw cash or buy more than you sell.
Partnership Techniques For A 1031 Exchange
Drop and Swap
Drop and swap refers to an exchange where a partnership interest is changed into Tenancy in Common (TIC) before the transaction. Each partner will essentially hold a fractional stake in the real estate rather than a share in a partnership that owns it.
As a result, each partner can act independently of the other partners upon the sale, including carrying out a 1031 Exchange or taking cash.
The biggest problem with this strategy is the issue of timing. However, there are specific ways for partners to end their partnership before the exchange takes place:
- At least a year before closing, change the property’s status from a partnership to TIC.
- Convert the property in escrow from a partnership to a TIC.
- The partnership’s assets should be distributed well before the sale to ensure this method conforms with 1031 Exchange regulations.
- The partners should keep the shared asset for two years before its actual sale, and the distribution should take place long before the sale of the property.
- The property allocation and final sale should at the very least take place in different tax years.
- Property must be used in a taxpayer’s trade or business or held for investment reasons to qualify for 1031 Exchange treatment.
- Resell-oriented property is not eligible for tax deferral treatment.
Additionally, the IRS might assert that the partners kept their proportional interests in the property given up if they held off on distributing the property until too close to the time of sale. This condition will make the property ineligible for a 1031 Exchange.
Swap and Drop
This method refers to a transaction in which a partnership interest later changes to TIC. Each type of partnership has benefits and drawbacks that an experienced lawyer should examine.
The swap and drop method may be helpful if the real estate sale closing date is quickly approaching and the property is still unsplit out of the partnership.
To carry out a 1031 Exchange, the individual partners would choose the specific properties they wished to trade. In addition to concluding the exchange into the desired replacement properties, the partnership will finish the sale of the property.
Furthermore, the partnership will retain ownership of these assets for about two years, after which the partnership will transfer the relevant properties to the individual partners.
Partnership exchanges result in a tremendous deal of uncertainty. Because TIC ownership structures enable individual investors to trade into and out of specific investments while applying Section 1031, they are the preferable type of partnership if you wish to invest with partners.
Dissolve The Partnership and Distribute TIC interests
Before the 1031 Exchange, dissolve the partnership and assign a TIC interest to each member. It helps to transfer ownership to individual partners as early as possible before the exchange.
Furthermore, the main concern is whether they used the old or new property for investment or constructive business if a split or liquidation occurs shortly before or after the exchange.
For the swap to be successful, individual exchangers must satisfy the qualified use condition. But it can be tricky when the distribution occurs right before or after buying or selling property. By giving an undivided interest to the cash-out partners before the sale, it may be possible to circumvent the qualified use problem and enable the partnership to continue and execute a 1031 Exchange.
Sharing an Undivided Interest
An audit can hardly reject a 1031 Exchange if the cash-out partners split their partnership interest into an undivided interest before the finalization of the sale. The remaining partners may complete the 1031 Exchange if at least one of the two partners was a partner before they redeemed the property.
Each former partner receives cash at closure, and the surviving partnership transfers its stake in the old property. For the partnership to finalize the exchange once it finds a new property, the Qualified Intermediary obtains the net proceeds owed to the partnership. In this instance, the best option is to redeem the cash-out partners early before the sale contract is signed.
Acquire a Retiring Partner’s Interest
The partners interested in trading can contribute extra equity before the exchange to replace a retiring partner. The partnership then engages in a trade with fewer partners. The partnership must purchase a new or replacement property with equal or more value than the old or relinquished property to entirely postpone taxes.
The partnership often refinances the replacement property to produce the funds required to buy out the retiring partner if the buyout happens after the exchange. You can use this method either before or after a 1031 Exchange.
A partnership may split into two or more partnerships by applying the partnership division rules of IRC 708(b)(2). A new partnership is regarded as the continuation of the previous one if it includes partners who collectively owned over 50% of the first partnership.
While there may be many continuing partnerships, the one with the highest fair market value will keep using the original partnership’s Employer ID Number (EIN). The partnership division will result in the issuance of new EINs to all other partnerships. This method can be used before, during, or after an exchange.
The IRC Section 761(a) permits a partnership to circumvent taxation by treating the individual owners as TICs rather than as owners of interests when determining how much of the partnership’s assets each owner holds. TICs can swap their proportional interests in properties a partnership holds into other derived property under a 1031 Exchange.
Section 761(a) is subject to different restrictions that might make compliance challenging. You should consult your financial advisors for specific information on your particular circumstance.
Relinquished Property Sale and An Installment Note
This procedure entails the relinquished property buyer making a cash payment and an installment note. The partnership uses the cash, and the retiring partner gets the installment note in exchange for the redemption of their partnership stake.
A valid installment note should be treated as an installment sale under IRC Section 453 if there’s at least one payment in the subsequent tax year. It would help to make at least 5% of the total payments in the upcoming tax year.
Partnering to Purchase Many Homes
It is legal to apply partnership division when both partners want to swap different properties. However, it is not advisable since only one of the resulting partnerships can keep the first partnership’s EIN. They would rather see the partnership buy several replacement properties.
As part of the exchange, the partnership would acquire two replacement properties. The agreement terms are also modified to distribute each partner’s revenue and amortization from the properties.
The process of organizing a partnership/LLC cash-out transaction is anything but uncomplicated. As a result, it’s crucial to consult a qualified tax expert before conducting a 1031 Exchange.
The sooner you start planning, the better. If you need help planning a 1031 Exchange, contact us today and let our team of experts help you.