Partnerships and Section 1031 Exchanges
Available Options for Partners and Partnerships
Like any other taxpaying entity, a partnership (and a limited liability company taxed as a partnership, generally referred to herein as a
“partnership”) can engage in a like-kind exchange under IRC Section 1031 to defer capital gain taxes. 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. What alternatives are available to the partners?
PARTNERS DOING SEPARATE EXCHANGES
An exchanger must own a capital asset to do a 1031 exchange. The fact that a partnership owns a capital asset does not mean that the individual partners have an ownership interest in that asset which is independently exchangeable. The partners merely own partnership interests, and partnership interests are specifically excluded from §1031 under Subsection 1031(a)(2)(D). Therefore, if an individual partner were to do a 1031 exchange, the partner would have to convert his or her partnership interest into an interest in the capital asset owned by the partnership.
One method for accomplishing this, known as a “drop and swap,” involves the liquidation of the partnership interest by distributing a different type of interest in the property owned by the partnership. This process of liquidating the partnership is the “drop.” After completion of the drop, the (former) partners will have converted their partnership interests into exchangeable interests in the underlying capital asset itself, as a tenant-in-common with the partnership. The property can then be sold, with the former partners each entitled to do what they wish (sale or exchange) with their respective interests.
Related to the “drop and swap” is the “swap and drop.” This involves the same two steps but in reverse order. The partnership completes the exchange (the “swap”) and then distributes an interest in the replacement property to the departing partner or partners.
HOLDING PERIOD ISSUES
Both the “drop and swap” and the “swap and drop” alternatives raise potential holding period issues. If the “drop” occurs too close in time to the “swap” (or vice versa), there may be some question as to whether the relinquished property (or replacement property) was “held for investment.” Also, if the drop appears too close in time to the swap, the partner’s exchange may be deemed an exchange by the partnership under the Court Holding case (See Commissioner v. Court Holding Co., 324 U.S. 331, 65 S.Ct. 707 (1954). Clearly, the more time that passes between the “drop” and the “swap” (or vice versa), the better.
Regarding the above issues, a line of federal cases (Bolker, Mason, Maloney, etc.) provides taxpayer-friendly authority against challenges by the IRS. However, some state taxing authorities (notably, the California Franchise Tax Board) aggressively challenge 1031 exchanges and argue that they are not bound by these federal cases. Also, changes made in 2008 to the federal partnership tax return (IRS Form 1065) make it easier to detect when drop and swap transactions have occurred, thus making such transactions more vulnerable to challenge by taxing authorities.