Partners, Partnerships, LLCs and 1031 Exchanges

IRS Tax Lawyer

IRS Tax Lawyer

Since a partnership is considered a taxpayer, they are able to participate in like-kind exchanges to defer tax payments on capital gains. Limited liability companies that are taxed as partnerships are also allowed to engage in 1031 exchanges that defer taxes and promote investment opportunities. However, the individual partners in the partnership must all have the same overall goals for the outcome of the sale of the property, otherwise the exchange can become difficult, like a IRS tax lawyer Baltimore, MD from a tax firm like Crepeau Mourges can advise. One partner may want to do the exchange, while another may want to do an exchange on their individual portion of the property owned, and others may not want to do the exchange at all. What happens when partners disagree on the terms of the exchange, and what options are available when there is a dispute?

Separate Exchanges For Individual Partners

Taxpayers must own a capital asset to engage in a 1031 exchange. Although partnerships may own capital assets, not all individual partners may wish to have ownership interest in the capital asset. Partners own partnership interests, which are excluded from 1031 exchanges. So, how does a partner go about a 1031 exchange if they own a partnership interest that is directly excluded from the exchange laws?

Partners that wish to do a 1031 exchange on their portion of the property separately from the partnership must convert their partnership interest into a capital asset that is owned by the partnership. By converting to a capital asset, they are then able to successfully complete the exchange and defer taxes made on the sale of the asset. One way of converting partnership interest into a capital asset is referred to as a “drop and swap.” In a drop and swap, partnership interest is liquidated by distributing an interest in the partnership’s property. This is known as the “drop”, and the former partner’s partnership interest is converted into an interest in the property as a tenant-in-common with the partnership. The partnership can then be sold with the former partner and partnership able to do as they please regarding the sale, or exchange, of the property. Another way of allowing partners to do separate things regarding the sale of a property is a “swap and drop”, which basically involves the above steps but reversed. The property is exchanged by the partnership, then interest in the replacement property is distributed to any partners wishing to leave the partnership.

The more time that passes in between the partner liquidating his or her partnership interest (the drop) and the actual exchange of the property (the swap) the better. If there was too little time that passed between the two occurring, then it may be questioned whether the initial property or the replacement property was being held for investment by the partnership. The IRS or other taxing authorities may question the legitimacy of the process, and the taxes may or may not be deferred. Some taxing authorities are more strict on the regulation of partnerships dissolving and allowing certain ones to complete the exchange with tax deferral on the sale of the property while other partners may wish to cash out or pay the taxes altogether. Changes in the federal partnership tax return make it easier for tax authorities to track the allotted time in between the drop and the swap, which may make the partnership more vulnerable to unsuccessful 1031 exchanges.