THE 1031 EXCHANGE INSTITUTE

Historically Partnerships were the Entity of Choice

The entity of choice for investment in real estate during the 1960s, 1970s and especially into the 1980s were either general partnerships (GP) or limited partnerships (LP). Partnerships were easy to set-up. Partnerships were pass-thru entities for income tax purposes so that the underlying investors (partners) could benefit from pass-thru depreciation. And, limited partners had liability protection.

It was an easy way to get real estate investors together under a common ownership structure in order to raise capital to acquire interests in large investment real property. Corporations created double taxation issues and Limited liability companies had not been created yet.

Today the Limited Liability Company is the Entity of Choice

Today, we have limited liability companies, which for the most part are treated as partnerships for income tax purposes if they have more than one member (owner) in the limited liability company. I will refer to general partnerships, limited partnerships and multiple member limited liability companies as "partnerships" for purposes of this article since the issues are virtually the same. Single member limited liability companies are treated differently and are discussed separately below.

Acquisition of Real Estate

Investment real property historically was acquired by either a general partnership or a limited partnership. Today, the majority of investment rental property is acquired by limited liability companies if a separate legal entity is deemed necessary or by individual investors as tenants-in-common or TICs. The tenants-in-common or TICs will often be individual single member limited liability companies or other separate legal entities as deemed appropriate by those involved with the investment.

Property Owned and Held by a Partnership

When an entity is selected to acquire the investmen real estate, legal title to the property will be held by the partnership (entity). The real estate investor, whether they are a partner in a partnership or a member in a limited liability company, does not own a direct interest in the investment real estate but actually owns a personal property interest in the partnership (entity). The partnership in turn actually owns the direct interest in the investment real estate.

This is an extremely important distinction when the real estate investor is planning to dispose of the investment property by structuring a 1031 exchange.

Complications Between 1031 Exchanges and Partnerships

Acquiring and holding legal title to investment real property in a partnership (entity) can create very difficult challenges when also structuring 1031 exchange transactions. As stated above, the real estate investor does not actually own a direct interest in the investment real estate. The partnership owns the real property interest.

Who Owns the Real Estate Anyway?

We must carefully analyze the prospective 1031 exchange transaction and all of the parties involved in the transaction to determine at what level the 1031 exchange must be structured. In other words, who actually owns the investment real estate and who is the actual seller of the investment real estate? Is the partnership or the real estate investor the real taxpayer in the subject transaction?

This question is not always as easy as it sounds, and there are a number of transaction structures available to the real estate investor when a partnership is involved and some or all of the partners wish to complete a 1031 exchange.

Partnership Completes Taxable Sale

The partnership can change nothing and complete the sale of the subject relinquished property and then subsequently distribute the net proceeds among the individual partners. However, this strategy will result in a taxable disposition for the partnership and to the individual partners and is therefore not a preferred solution.

Partnership Completes 1031 Exchange

The simplest solution is to have the partnership complete the 1031 exchange. It does not matter what type of partnership it is or how many partners (owners) there are as long as the partnership sells the relinquished property and then subsequently acquires the like-kind replacement property as part of the 1031 exchange transaaction. The 1031 exchange is structured and reported at the partnership level.

The partnership continues to exist and the acquired replacement properties continue to be held by the partnership. This structure requires that the partnership stay intact and that any and all partners (owners) of the partnership entity stay together for a period of time in order for the 1031 exchange to qualify for tax-deferred exchange treatment.

Individual Partners Complete 1031 Exchange

The more common situation is one where the partnership has multiple partners (owners) that do not want to remain together. The individual partners wish to sell the investment real estate and each partner (owner) wishes to go their separate way. Remember that partners do not own a direct interest in the real estate but actually own an interest in the partnership itself, which a personal property interest rather than an interest in investment real estate.

This situation creates a much more complex 1031 exchange and requires special proactive planning prior to structuring and closing a 1031 exchange transaction.

Drop and Swap Structure

The partnership can distribute the investment real property to the underlying partners so that the partners now hold title as a direct ownership interest in the real property as tenants-in-common or TICs. This solution is referred to as a 'drop and swap' 1031 exchange structure or strategy. It is also generally recommended that the individual partners hold title and treat and report the property as tenants-in-common or TICs for at least 12 or more months.

Swap and Drop Structure

Conversely, the parternship could retain the investment real property inside the partnership and sell and complete the 1031 exchange at the partnership level instead of distributing the investment property to the individual partners. The partnership would hold and report the investment real estate for at least 12 or more months and then distributed the investment property out of the partnership to the individual partners. This is referred to as a 'swap and drop' 1031 exchange structure or strategy.

There are many many variations to these strategies outlined above and depend on the individual goals and objectives of the individual partners.

Seek Legal and Tax Counsel

Partnership issues with 1031 exchanges are extremely complicated, so it is important that the real estate investor always seek competent legal, tax and financial counsel with experience in partership issues with 1031 exchanges prior to structuring any 1031 exchange.

Single Member LLC

There is an exception to the rule when a single member limited liability company is involved. We will refer to the single member limited liability company as a SMLLC. The SMLLC is a pass-thru entity and also considered to be a disregarded entity for income tax purposes. The SMLLC is not considered a partnership and the above issues do not exist when there is a SMLLC involved.