April 2008 1031 Advisor

Recent events in the financial markets highlight the frequent, yet painful, lesson that commonly accepted thinking is not always correct thinking. Exchanges of partnership assets and partnership interests commonly fail to appreciate the inherent tax risks which accompany these types of exchanges.

Assume the following scenario: A Limited Liability Company, which is owned equally by four individuals, sells an appreciated asset. Two of the members/partners want to cash out of their investment. The following is a summary of techniques used by many advisors.

TIC Arrangement (a.k.a. “Drop and Swap”): The LLC or partnership distributes the Property to each of the members before the sale as a Tenancy In Common interest. Two former members purchase replacement property and two members cash out. This transaction faces several hurdles to be treated as a tax deferred exchange.

Issue #1: “Held for sale” vs. “Held for investment”: The individual members, now co-owners of the relinquished property, must satisfy the statutory requirement that they “held the property for investment” prior to the sale. If the property was distributed after the sale negotiations were initiated, this property could be treated as “held for sale” rather than held for investment.
Issue #2: Increased taxes: If the IRS treats this transaction as not qualifying as a proper 1031 Exchange, the selling individuals would pay ordinary income rates on the sale, as either short term capital gains or as inventory, thereby doubling his or her taxes.
Issue #3: “Inside” vs. “Outside” Tax Basis: If this investment was the sole asset of the LLC, the distribution of this property to the members prior to the sale would probably result in the member’s taxable gain or loss on the sale being measured by his “outside tax basis” in the LLC rather than the partnership’s “inside tax basis”. Generally, the outside tax basis is lower than the inside tax basis, thereby increasing the taxable gain further.
Issue #4: TIC Rules: Simply deeding property to members does not create a Tenancy In Common (TIC) arrangement. The tax regulations are fairly specific as to what does and does not qualify as a TIC arrangement.

Forward Exchange (aka “Swap and Drop”): The LLC or partnership sells the Relinquished Property, purchases the Replacement Property(ies) and distributes the Replacement Property (ies) to one or more of the members. This transaction faces several hurdles to be a treated as a tax deferred exchange. Federal tax law requires that the owning entity “Hold the Property for investment” requirement. How much time which must elapse between exchange and distribution is a factual issue that must be resolved.
Other Consideration: At-Risk Rules. The At-Risk rules of Section 465 can ruin a real estate investor’s day in hurry. For exchanges that cross over the end of the taxable year, failure to acquire “qualified non-recourse financing” before the end of the taxable year can cause recapture of income equal to the sum of prior losses taken up to the amount of the qualified non-recourse financing paid on the sale of the relinquished property
"Can’t we just allocate all the gain to the departing Partner(s)?" For ordinary mortals with fairly standard operating agreements, the answer is generally “No”. Some operating agreements may be set up to anticipate this result, but it cannot not be done right before a sale and past muster under the Section 704(b) Substantial Economic Effect Tax Regulations.
Partnership Divisions: Yes, this can be an excellent method to exchange partnership property when some partners want to exchange, and other partners do not.

The bottom line: Beware. There are many advisors who suggest or implement transactions that compromise the legitimacy of Section 1031 Exchanges, or trigger increased taxable gains. It may be appropriate to seek a “second opinion” before planning your 1031 Exchange in order to maximize your tax savings.

How can you know if your Exchange of Partnership Assets/Interests is structured for maximum tax benefits? Our tax professionals at Strategic Property Exchanges, LLC are available to discuss your individual situation, and provide you with a first (or second!) opinion. We guarantee the tax results of the 1031 Exchange. Stephen L. Robison, Esq, is a Qualified Intermediary and is a full time practicing tax attorney, and is Board Certified as a Federal Tax Specialist. Mr. Robison, and our team of professionals, will work with you and your clients. They will creatively and strategically assist you and your client with all types of exchanges in order to maximize the tax deferral opportunities.