1031 Exchange Partnership Issues

Investment real estate is commonly owned by multiple owners in a partnership or by multiple owners as tenants in common to an undivided interest in the underlying real property. An exchange of a tenant-in-common interest in real estate poses no problems and is eligible for 1031 Exchange treatment. However, an exchange of an interest in a partnership is not permitted under the Code and Regulations. Careful forward planning is required to ensure a successful 1031 exchange where partnership issues are involved.

If a partnership owns property and desires to sell and exchange it, the partnership is the entity or party to the like kind exchange. Since the partnership will take title to the replacement property, no issues are apparent during the exchange period. However, if the partners wish to split up immediately after the exchange, the "held for" requirement may not be met on the replacement property. The partnership would need to retain ownership of the new property for an unspecified period of time (one year is commonly thought to be sufficient) to meet this qualification. Once sufficient time has passed, the partnership can then dissolve and distribute the property - through deed to individual properties or tenant-in-common ownership - to the former partners.

If a partnership wishes to exchange property but one or more of the partners want to "cash-out" or go their separate way(s), it is common for the partnership to split out the ownership before the sale. The partnership distributes tenancy-in-common title to the individual partners who wish to proceed in separate directions. The partnership (and its remaining partners) would then proceed with an exchange of the remaining ownership in the name of the partnership.

Frequently, individual partners desire to end the partnership relationship when the owned property sells. They would prefer to take their share of the partnership sale proceeds and buy qualifying 1031 replacement property in their own names. Far too frequently, the partnership gives each individual their undivided tenant-in-common interest in the old property just days or hours before closing. The plan is for each partner to take ownership in his or her name and individually complete a 1031 exchange. This lack of planning presents problems. The entire exchange could fail since the partnership could be seen as the selling entity that did not take title to qualifying replacement property. The individual owners have not met the "held for" requirement as they only owned the property in their individual names for a short period of time.

If partners wish to discontinue the partnership, sell the property and go their separate ways - with either the cash or a 1031 Exchange - it is necessary for the individual partners to receive deed to the property from the partnership in advance of the sale of the property. This is done through a distribution of property from the partnership to its individual partners. The partners are then generally required to hold the property as tenants in common for an unspecified period of time (decent interval of time) in order to comply with the "held-for" requirement of a 1031 Exchange that requires a taxpayer to have "held" qualifying property for business or investment purposes prior to the exchange.

The services of a tax professional are essential for tax planning purposes. An experienced Qualified Intermediary is also needed to ensure a successful exchange structure where partnership and co-ownership real estate interests are involved. To view more on partnership issues or other issues related to 1031 exchanges, take a look at this 1031 Exchange Manual or give us a call at 888-367-1031.