Chapter § 55.12 PARTNERSHIP EXCHANGES

• Jurisdiction: Oregon

§ 55.12 PARTNERSHIP EXCHANGES

§ 55.12-1 Partnership Basics

The Internal Revenue Code defines a partnership as an enterprise by which "any business, financial operation, or venture is carried on." IRC § 761(a).

For income-tax purposes, a limited liability company with more than one member, unless it elects to be treated as a corporation, is treated as a partnership. Treas Reg § 301.7701-3(a)-(b). A partnership (even a tenancy-in-common relationship that is determined in fact to be a partnership) files an IRS Form 1065 income-tax return. A partnership is never subject to tax at the partnership level. All income and losses are recognized by the partners. IRC § 701.

Determining what is and what is not a partnership is not always easy. A tenancy-in-common relationship can easily be a treated as a partnership. Some relationships that appear to be a partnership might be something else, such as an agency relationship. Even a loan might really be a partnership. For example, if the lender's payments are subject to available cash flow, there is little or no security, and interest is a percentage of profits of the venture, the loan would probably be classified as a partnership for tax purposes.

§ 55.12-2 Exchange by Partnership

A partnership can of course enter into a tax-free exchange. As long as the partnership as an entity both sells or transfers the relinquished property, receives the replacement property, and complies with all the IRC section 1031 legal requirements, the exchange will be tax free. Because of the dual nature of a partnership (an entity versus an aggregation of individuals), exchangers are often confused about the precise nature of the transaction into which they wish to enter. For example, in Technical Advice Memorandum 1999-07-029 (Feb 19, 1999), four individuals (A, B, C, and D) owned an apartment building and filed partnership tax returns for 20 years. The apartment complex was destroyed and the property was sold. Partner C sold its interest in the property for cash. Partners A, B, and D, using separate exchange agreements, purchased a replacement property together. The IRS ruled that because A, B, and D owned more than a 50 percent interest in the partnership, the partnership continued and the exchange was successful. This was despite the fact that instead of one exchange agreement, there were three exchange agreements, one for each of the three exchanging partners. The cash boot that partner C received was taxable to the partnership; thus, partners A, B, and D also had to pay tax on the cash received by partner C. Cf. Sandoval v. C.I.R., 79 TCM (CCH) 2163 (2000) (when exchangers held relinquished property as tenants in common, but acquired replacement property in a partnership, transaction did not qualify as like-kind exchange).

§ 55.12-3 Partnership Interests

Although a partnership can exchange its interest in any property as part of a tax-free exchange, a partner cannot exchange a partnership interest in a tax-free exchange because partnership interests are not qualified property for purposes of a tax-free exchange. IRC § 1031(a)(2)(D); 26 CFR § 1.1031(a)-1(a)(1)(iv). Thus, a general or limited partner in a real estate partnership, or a member in a limited liability company, cannot complete a tax-free exchange of his or her interest in the partnership or company for real estate.

§ 55.12-4 Exchanges Involving Multiple Partnerships

Occasionally a situation will arise in which A and B are partners in two or more partnerships involving separate real estate. If A and B wish to separate themselves, they can merge all of their partnership interests into a single partnership (which by election can be treated as a distribution or contribution). Thereafter, the partnership can distribute properties with a value equal to B's equity to B. Under IRC section 704(c)(2), as long as the properties are of a like kind, and as long as the redemption is made within 180 days of the organization of the merged partnership, or the day the tax return is due, the transfer will be treated exactly like a tax-free exchange. To prevent A's partnership from terminating, someone such as A's spouse will have to become a partner in the continuing partnership.

§ 55.12-5 Exchange Followed by Transfer to Partnership (Swap and Contribute)

§ 55.12-5(a) Magneson Holding

In Magneson v. C.I.R., 753 F2d 1490, 1495-97 (9th Cir 1985), the tax court allowed an exchange followed by an immediate transfer of the replacement property to a partnership (in which the exchanger was a general partner) under the theory that a continuity of investment existed and the contribution was merely a change of form of ownership. The court framed the issue as "whether property acquired in a like-kind exchange with the intention of contributing it to a partnership . . . is 'held' for investment within the meaning of Internal Revenue Code § 1031(a)." Magneson, 753 F2d at 1492. The court held that the property was held for investment because the transfer was a "continuation of the [exchanger's] investment unliquidated but in a modified form." Magneson, 753 F2d at 1493, 1497.

§ 55.12-5(b) IRS Attack

Despite the ruling in Magneson v. C.I.R., 753 F2d 1490 (9th Cir 1985) (see § 55.12-5(a)), the IRS could use three theories to attack an exchange followed by a transfer of the replacement property to a partnership:

(1) The partnership was really the buyer of the replacement property. In this event, the exchanger never actually received the replacement property and thus did not complete a tax-free exchange. The exchanger was the partnership's agent in acquiring the replacement property or was acting in his or her capacity as a partner, and thus the fact that the exchanger momentarily held the replacement property should be ignored. The court used this step-transaction doctrine in True v. United States, 190 F3d 1165, 1181 (10th Cir 1999) to deny section 1031 exchange treatment involving contribution of the replacement property to a partnership.

(2) The exchanger did not hold the replacement property for investment or in his or her trade or business as required by IRC section 1031. It is clear that by transferring the property to the partnership, the exchanger held the replacement property only for the purpose of immediately transferring it to the partnership, and the fact that the partnership will hold it for investment is irrelevant in determining the exchanger's intent in acquiring the property because the partnership is a separate taxable entity from the exchanger.

(3) The transfer involves an exchange of real property for a partnership interest, in violation of IRC section 1031(a)(2)(D).

NOTE: In a well-reasoned opinion in Dep't of Revenue v. Marks, 20 Or Tax 35, 52-53 (2009), which unfortunately is not binding on the IRS, the Oregon Tax Court held that Magneson was applicable and refused to tax the taxpayer in a Magneson-style swap-and-contribute transaction.

§ 55.12-5(c) Distinguishing Magneson

The case of Magneson v. C.I.R., 753 F2d 1490 (9th Cir 1985), is contrary...