Like-kind exchanges of partnership properties.

AuthorSmith, Michael M.

EXECUTIVE SUMMARY

* A partnership can distribute real property to its partners so that the partners can exchange the property in a Sec. 1031 like-kind exchange; if the exchange is properly structured, some of the partners can trade their interests in the property distributed in Sec. 1031 exchanges and some of the partners can sell their interests in the property in taxable transactions.

* When challenging the validity of a Sec. 1031 exchange of property distributed by a partnership, the IRS will likely use one or more of three theories: (1) the partners did not hold the property for a qualified use, (2) the step-transaction doctrine, and (3) the partners' cotenancy in the property is a partnership.

* As an alternative to distributing the property before the exchange, a partnership. could exchange the property for cash and installment notes, buy replacement property with the cash, and distribute the installment notes to partners who wish to withdraw from the partnership.

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[ILLUSTRATION OMITTED]

Owners of real estate often use Sec. 1031 to make tax-deferred exchanges of underperforming properties for newer replacement properties. However, when the real estate is held in a partnership or a limited liability company (LLC) having multiple owners (that is treated as a partnership for tax purposes), the exchange can become complicated if one or more of the partners (or members) wants to withdraw from the partnership or LLC without participating in the exchange transaction.

A withdrawing partner cannot simply take cash for a beneficial interest in a real estate transaction without affecting tax treatment to the remaining partners. Moreover, exchanges of partnership interests expressly do not qualify for tax-free treatment under Sec. 1031(a)(2)(D). Accordingly, for a partnership to receive tax-free treatment, the exchange must occur at the partnership level or the partners desiring individual tax-flee treatment must receive a real estate interest from the partnership that they can exchange individually or along with the interests of the other partners who desire tax-free treatment. This article summarizes various potential alternatives--and their related tax risks--that are available when considering an exchange involving real estate owned by a partnership or an LLC treated as a partnership for tax purposes.

Exchange After Distribution to Partners

One possibility for achieving tax-free treatment at the partner level is for the partnership to distribute its real property to its partners on a pro-rata basis (according to their respective interests in the partnership) and then dissolve. (1) A distribution by a partnership will generally be tax free under Sec. 731. The resulting former partner cotenants, holding the real estate as tenants in common, could then collectively enter into an agreement with a third-party purchaser for the sale of the relinquished property while reserving their rights to effect separate exchanges (tax flee) or receive cash (taxable) for their respective interests therein. Each such cotenant thereafter desiring exchange treatment could then assign his or her respective interest in the sales contract to a qualified intermediary and close the transaction as an exchange. Those cotenants wanting cash could then treat their respective portion of the disposition as a taxable sale and report the transaction as a taxable event on their income tax returns.

Exchange Prior to Distribution to Partners

Assuming that all partners desire tax-free exchange treatment but want to end up with separate properties and then dissolve the partnership, the partnership itself could exchange on its own the relinquished property and enter into contracts to acquire several replacement properties, each suitable to its respective partners. Following the closings, the partnership could then distribute the separate properties to the respective partners, as the partners may agree, in liquidation of the partnership. (2)

Instead, prior to the tax-free transaction, if some of the partners want to continue in the partnership and others want out, the partnership could "cash out" the withdrawing partners in a redemption...

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