Taxpayers who own real property in a business or for investment consider a 1031 exchange when selling and replacing with “like-kind” property. The alternative is to pay the federal and state capital gain and depreciation recapture tax that can represent up to 40 percent of the sales price. A 1031 exchange defers or postpones the recognized gain or tax due if a series of rules are followed. The tax is eventually due when the replacement property is sold and another 1031 exchange is not initiated. The 1031 exchange allows those otherwise paid tax dollars to be used as interest free working capital towards the replacement property acquisition.
Ineligible for 1031 Exchange
Any real property held in the productive use of a business or for investment is eligible for 1031 consideration. Land can be exchanged for commercial property or a multitude of other types of real property. The following is ineligible for a 1031 exchange:
- Primary residence
- Indebtedness
- Inventory
- Stocks and Securities
- Partnership Interests
Partnership Interests
The legal definition of partnership interest is “an association of two or more persons to carry on as co-owners a business for profit.” Partnerships may contain individuals or corporations. In 1984, partnership interests were excluded from non-recognition treatment under Internal Revenue Code § 1031; however, there are a couple of exceptions.
Revenue Ruling 99-6
Per the Omnibus Budget Reconciliation Act of 1990, “an interest in a partnership that has in effect a valid election under Internal Revenue Code (I.R.C.) Section 761(a) to be excluded from the application of all of subchapter K is treated for purposes of I.R.C. § 1031 as an interest in each of the assets of the partnership and not as an interest in a partnership.”
Revenue Ruling 99-6 allows a taxpayer in a 1031 exchange who is already a partner in the partnership to purchase all of the remaining interests of the other partners in the partnership. For example, if Jack and I are 50/50 partners in a partnership that owns the replacement property, Jack who has initiated a 1031 exchange, can buy my interest as replacement property. Under Revenue Ruling 99-6, the acquisition is treated as if the partnership first liquidated, then Jack, acquired a 50 percent interest in the underlying real estate.
Revenue Ruling 99-5
Per Rev Ruling 99-5, “if a taxpayer owns 100 percent of a disregarded LLC and the taxpayer sells a portion of the LLC interests to a buyer, the taxpayer is treated as if it first sold an undivided interest in the assets of the LLC and the taxpayer and the buyer then contributed their undivided interests to a new partnership. Therefore, the sale of the LLC interests by the taxpayer could be structured as an exchange by the taxpayer of an undivided interest in the underlying property.” A buyer acquiring a portion of the LLC interests is considered as a contribution to the new partnership, qualifying the LLC interests as replacement property in a 1031 exchange given the buyer acquires the interests to hold in the productive use of a business or for investment and not for flipping or for profit.
Drop and Swap
Partnerships experience challenges when, following the decision to sell the underlying property, one partner wants to cash out and the other wants to defer the gain in a 1031 exchange. The same taxpayer requirement of the 1031 code requires the taxpayer who sells to be the taxpayer who buys. With proper planning as far in advance of the purchase and sale agreement, one option is to dissolve the partnership, dropping title from the partnership to the individuals or tenants in common. Once as tenants in common, one taxpayer can cash out while the other taxpayer defers their gain in a 1031 exchange.
Dissolving the partnership should be reviewed with your CPA or tax attorney. Attention should be given to IRS Form 1065, questions 13 and 14. Dropping too close to the closing date may cause the IRS to question the 1031 exchange given the short time the new titleholders hold the property.
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