Mcle Self Study Article: 1031 Exchanges and Real Estate Partnerships—swaps, Drops, Pins, and Rago

• Jurisdiction: California,United States
• Citation: Vol. 34 No. 1
• Publication year: 2016
• Author: William F. Webster
• topic: Business of Law,Tax Law,Real Estate

MCLE Self Study Article: 1031 Exchanges and Real Estate Partnerships—Swaps, Drops, PINs, and Rago

Check the end of this article for information on how to access one MCLE self-study credit.

William F. Webster

William F. Webster is a sole practitioner in Roseville, California. His practice is primarily in the areas of business transactions and entity formation involving tax and securities laws, and estate planning. Prior to opening his own firm, Mr. Webster was in-house counsel at a 1031 exchange qualified intermediary. Mr. Webster can be reached at billfwebster@gmail.com.

Tax-deferred exchanges under section 1031 of the Internal Revenue Code ("IRC") ("Section 1031") are a regular feature of the real estate landscape. One aspect that has gotten particular attention is an exchange of property by a partnership or LLC¹ in which various partners may have differing ideas about what they want to do going forward, and some partners may want to leave the partnership altogether and do separate exchanges. This article briefly reviews Section 1031 basics and then focuses on various exchange techniques used by partnerships and partners, including "drops and swaps" and related transactions, and the use of a partnership installment note ("PIN"). The article concludes with an examination of the recent California State Board of Equalization opinion in Appeal of Rago Development Corp. ² and its ramifications for partnership exchanges in California.

I. IRC SECTION 1031

Section 1031 allows a taxpayer to defer the recognition of gain on the disposition of "property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind."³ Although Section 1031 was originally intended to enable tax deferral for direct exchanges of property between two taxpayers, most exchanges now take the form of "deferred exchanges" using a qualified intermediary, enabling a single taxpayer to sell relinquished property to one party and purchase replacement property from a different party. Deferred exchanges are subject to detailed rules provided by treasury regulations.⁴ The regulations provide safe harbors that, if their strict rules are complied with, provide certainty as to the viability of multi-party deferred exchanges.⁵

In any exchange, the replacement property must be of like-kind to the relinquished property. "Like-kind" is defined very broadly with regard to real estate.⁶ Generally, any interest in any real estate is like-kind to any other interest in real estate. For example, a commercial building is like-kind to an apartment complex, a residential rental property, or bare land. A fee simple interest in real property is like-kind to a tenant in common interest in real property. Specifically excluded from eligibility under Section 1031, however, are "interests in a partnership."⁷ Therefore, an interest in a partnership that owns real property (as opposed to an interest in the real property itself) is not eligible for a 1031 exchange.

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Like any taxpayer, a tax partnership can engage in a 1031 exchange with property owned by the partnership. Difficulties can arise, however, when the individual partners desire different outcomes with regard to the sale of property by the partnership. Some partners may wish for the partnership to stay together and do an exchange; others may want to do their own exchange with their portion of the property; still others may wish to receive cash and simply pay the tax. A variety of techniques have evolved to address these contingencies.

II. PARTNERSHIP EXCHANGES—DROP AND SWAP, AND VICE VERSA

For the next few sections, assume the following facts: ABC Partnership has five partners, each of which owns a twenty percent partnership interest. ABC owns a single asset—a commercial building with a fair market value of $1,000,000 (the "Property"). ABC's basis in the building is $500,000. ABC is getting ready to sell the property.

A. Drop and Swap

Assume that two of the partners would like to leave ABC Partnership. When ABC sells the Property, each of these partners would like to do a separate 1031 exchange with their share of the proceeds from the sale. Clearly, they cannot do exchanges with their partnership interests in ABC. Each partner must own an interest in the Property itself before that partner can do a 1031 exchange. The partnership needs to "drop" an interest in the Property to each of the two partners before the partners can then do a "swap" (1031 exchange) with their undivided interests in the Property. This can be accomplished by a redemption (or "complete liquidation" in partnership tax parlance) of the two partners' partnership interests by ABC in exchange for the distribution by ABC of an undivided interest in the Property to each of the two partners. At the end of that transaction, the Property will be owned by ABC (sixty percent) and the two partners (twenty percent each) as tenants in common. Under IRC section 731, neither the partnership nor the partners will recognize gain on the distribution. Under IRC section 732(b), each partner's basis in the distributed interest in real property will be the basis in the partner's liquidated partnership interest.

If the swap occurs close in time to the drop, a "qualified use" issue may arise. That is, the IRS and/or state taxing authority could challenge the exchange by arguing that the interest in the Property sold by a departing partner was not property acquired with the intent to "hold for investment," but rather the partner acquired that property with the intent to transfer it pursuant to a 1031 exchange. This issue was addressed in Bolker v. Commissioner.⁸ In that case, a corporation liquidated and distributed its property to its sole shareholder. The distribution was tax-free under former IRC section 333. On the day of the distribution, the shareholder entered into an exchange agreement, and the exchange occurred three months later.

The court in Bolker found that the property was held for investment—and not with the intent to transfer it—despite the fact that the shareholder intended to exchange the property at the time he acquired it. The court found that a taxpayer could satisfy the use requirement even though the relinquished property was acquired for the purpose of being exchanged: although a taxpayer's intended use of the property is measured at the time it is acquired, the taxpayer is not required to intend to keep the property indefinitely.⁹ The court held that, "if a taxpayer owns property which he does not intend to liquidate or to use for personal pursuits, he is 'holding' that property for productive use in a trade or business or for investment within the meaning of Section 1031(a)."¹⁰ The court concluded that "the intent to exchange property for like-kind property satisfies the holding [and use] requirement, because it is not an intent to liquidate the investment or to use it for personal pursuits."¹¹

Bolker provides clear authority for the use of a drop and swap in partnership exchanges even when the drop occurs close in time to the swap as part of a pre-arranged plan. Bolker involved a distribution from a corporation. In Mason v. Commissioner,¹² decided several years later, the U.S. Tax Court held in favor of the taxpayer in a prearranged drop and swap involving a partnership.

B. Swap and Drop I

The term "swap and drop" has been applied to two different types of transactions. To illustrate the first type of transaction, assume again that ABC Partnership has entered into an agreement to sell the Property and plans to complete a 1031 exchange. Two of the partners wish to leave ABC Partnership. Instead of liquidating the partners' interests prior to the sale, as in a "drop and swap," the partners decide that ABC will complete the exchange and purchase several replacement properties, two of which will then be distributed to the departing partners in liquidation of their respective partnership interests after the exchange is completed. As with the drop and swap, this type of transaction may implicate qualified use or holding period issues. Since ABC Partnership will be acquiring its replacement properties and promptly distributing some of these properties to the departing partners, taxing authorities could argue that ABC did not acquire these replacement properties with the intent to hold them for investment.

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Once again, there is good case law at the federal level for the taxpayer to rely upon. Maloney v. Commissioner¹³ involved a swap and drop of the sort described above. In that case, a corporation completed a 1031 exchange and then distributed the replacement property to its shareholders shortly after acquisition. The distribution was tax-free under former IRC section 333. Regarding the corporation's acquisition of the replacement property, the court noted that the exchange "reflect[ed] both continuity of ownership and of investment intent."¹⁴ The court quoted Bolker extensively for the proposition that a like-kind exchange may be preceded by a tax-free acquisition of property at the front end or succeeded by a tax-free transfer of property at the back end, and for the proposition that "in short, where a taxpayer surrenders stock in his corporation for real estate owned by the corporation, he continues to have an economic interest in essentially the same investment, although there has been a change in the form of ownership."¹⁵

A partnership may consider using a swap and drop in a situation where the sale is imminent and there is not enough time to complete the redemption transaction involved...