Expanding on 1031 Exchange Solutions When a Partnership is Involved

This is our third blog post in our continuing mini-series of blog posts revolving around the challenges and planning problems that crop up when property that investors intend to sell and defer the payment of their capital gain taxes is owned inside of a general partnership or limited partnership.

You might want to read the blog posts in order so that they make more sense. The first blog post
introduces the issues involved. We will begin with this blog post to delve into the various solutions available to investors/partners when they are confronted with this challenge.

Be Proactive
The first and most important piece of advice that I can offer real estate investors is to be proactive when you own property through an entity, whether it be a limited liability company with multiple investors, general partnership, limited partnership, corporation, Title Holding Trust, or other type of entity. The majority of challenges that arrive based on entity issues can be solved given sufficient time to work through the problem.

Evaluate All Options
There are numerous solutions to most entity related problems as outlined in my second blog post in this series. You should review each options with your legal and tax counsel prior to moving forward to ensure that you select the solution that is most appropriate for you. The various solutions will involve varying degrees of risk and you need to fully understand all of your options before you proceed.

The Safest Solution
O.K. I took the easiest one first, which is to change absolutely nothing. Keep the entity in place and continue to hold the real estate in the same entity.

The property would be listed and sold through the same entity and then the replacement property would be acquired by/in the same entity. Nothing changes, and therefore there is no risk. You would structure, report and complete your 1031 exchange using the existing entity.

The problem here is that most of the time the co-investors do not want to stay together and the operation is going to be wound down and the entity is going to be dissolved. So, while this is the safest solution, it is usually not an option.

The Next Best Option
When the safest solution is just not a solution, we look to the next best option, which is generally the 'drop and swap' strategy.

Drop and swap is a clever way of describing the strategy where the property is "dropped" out of the entity (i.e. the property is deeded out of the entity into the individual investors' names), held for a period of time (generally recommended at a minimum of 24 months in order to demonstrate the individual investors' intent to hold the property as an investment), and then "swapped" (i.e. 1031 exchanged) at the investor level. This allows each individual investor to determine the best strategy for them and the entity can be dissolved.

The investor must be extremely careful here. Deeding property out of certain types of entities can trigger other income tax problems, so always review the structures with your tax advisor before proceeding.

I will address the rest of the strategies in my next blog post of this mini-series shortly, so stay tuned.