DISPOSITIONS OF PARTNERSHIP PROPERTY

Whenever more than one person or married couple owns real estate, there is a potential problem for the exchange.  If all of the co-owners wish to exchange into the same new property, there is no concern other than proper documentation for the exchange.

However, often not all of the co-owners wish to exchange into the same property.  Some co-owners may want to cash out of the investment, while other co-owners may want to acquire their own separate property through an exchange.

As long as the property is owned by the co-owners in their own right and not as a partnership, each of the co-owners can pursue their own investment goals without jeopardizing their co-owners' goals.

If, however, the Relinquished Property is either owned by a partnership or the IRS can assert the property was owned by a partnership, what each co-owner does becomes critical. 

The IRS will not allow a co-owner to exchange
a partnership interest for real estate.

Congress' 1984 amendments to Section 1031 specifically exclude the exchange of partnership interests.  Many commentators suggest that Congress intended to stop the exchanging of "burned-out" tax-shelter limited-partnership interests.  Unfortunately, the broad language of the amendments prevents the exchange of ANY partnership interest (General or Limited) for interests in real estate.

The Final Regulations for Deferred Exchanges further underscore the fact that the exchange of partnership interests are excluded under Section 1031.

There are four areas to review to determine if there may be disposition-of-partnership-property problem.

Title to the Property -- Where title to the property is in a partnership, the Exchangor will have to deal with partnership-exchanging concerns.  But where title is in co-owner's individuals' names, the next area of concern must be reviewed.

Partnership Agreement -- If title is in co-owner's names but a partnership agreement exists which includes the property as partnership property, the partnership owns the property for 1031 purposes,  even though record title is not in the partnership's name.

If it is determined that title to the Relinquished Property is in the co-owner's names, and there is no partnership agreement for that particular property, there is still one remaining area to review:

Partnership Tax Returns -- If a partnership tax return has been filed for a particular property, that property is partnership property for 1031 purposes, even though title is not in the name of the partnership, and even though there is no partnership agreement.

Partnership-like activities -- If the ownership of the property surrendered by the co-owners requires extensive business or management functions by the co-owners, the IRS can successfully assert that a partnership exists even though title is not held in partnership name.  The IRS argument hinges on the fact that the regulations define a partnership a joint undertakings if the participants carry on as trade, business, financial operation or venture and divide the profits thereform.  An example in the regulations holds that a partnership exists where co-owners of an apartment building lease space and, in addition, provide services to the occupants.

If any one of the foregoing elements present, there is a potential partnership problem.

If the Relinquished Property is going to be treated by the IRS as partnership property, can the goals of the "partners" be served by completion of a tax-deferred exchange?

The partnership, as an entity, can dispose of the Relinquished Property and the partnership, as an entity, can acquire the Replacement Property.  Real estate is exchanged for real estate by the partnership.

If not all of the partners want to be part of an exchange there is a problem.  The partnership could be prevented from disposing of the Relinquished Property and acquiring the Replacement Property as an entity.

When a partnership is in title and is going to act as the Seller of the Relinquished Property, it may be desirable to buy out the non-exchanging partner's interests in the partnership prior to the disposition of the Relinquished Property.  The partnership could then complete the exchange as an entity.

It may also be possible to buy out the non-exchanging partners' interests in the partnership after the acquisition of the Replacement Property if the non-exchanging partners are willing to wait for their share of the Relinquished Property disposition proceeds.

If it is not possible to buy out the non-exchanging partners prior to disposition of the Relinquished Property or after the acquisition of the Replacement Property, the partnership may want to consider dissolving the partnership (prior to listing the Relinquished Property for sale and prior to entering into a Purchase and Sale Agreement) and distributing interests in the Relinquished Property to the partners in proportion to their partnership interests.  1990 Amendments to Code Section 1031 allow the partnership to opt out of partnership tax treatment by filing a Section 761 election, as long as they actually operate and manage the property as joint owners.

The former partners may then use their newly acquired undivided real property interests for individual exchange purposes or for outright sale depending on their wishes.

Pitfall:  To dissolve the partnership, all of the partnership's property must be distributed in the dissolution.  If the partnership owns more than one property, dissolution may not be feasible.

Problem:  The IRS may characterize the acquisition of the property interest from the partnership as ineligible for an exchange!  The IRS may argue that the property interest just received from the partnership breakup was not held for investment purposes because it was immediately disposed of to acquire the Replacement Property.

Problem:  Revisions to Code Section 704 may make the distribution of the property to the partners in the breakup a taxable event for one or more of the partners.

In the case where there is more than just the Relinquished Property in the partnership,  the exchanging partners might receive an undivided interest in the Relinquished Property in partial or complete dissolution of their partnership interests.  In this circumstance, the IRS might still argue that the just-received property interest was not held for investment.  Concerns about Code Section 704 would still have to be addressed.

Another possible solution is to have the partnership, as an entity, dispose of the Relinquished Property, but distribute cash or other non-qualified property to the non-exchanging partners.

Because the partnership, as an entity, disposed of the Relinquished Property,  the cash or other non-qualified property which has been received by the non-exchanging partners would be normally taxable to the partnership and not be eligible for the exchange.  However, the non-exchanging partners can make a special election which will result in the non-exchanging partners being taxed rather than the partnership.  The partnership, as an entity, could then complete the exchange.

When it is decided to dissolve the partnership and distribute Relinquished Property to the partners, the following steps need to be taken before the Relinquished Property is listed for sale and well before the Relinquished Property is sold:

Step 1 -- Formally terminate any partnership agreement;
Step 2 -- Have the partnership's CPA file a final partnership tax return and    elect out of partnership tax treatment;
Step 3 -- Have the partnership deed the property to the individual partners    in undivided interests proportionate to their partnership interest.     (This deed is exempt from excise tax in Washington state and may    be exempt from transfer taxes in other jurisdictions.)
Step 4 -- Have the individuals dispose of the Relinquished Property, by sale    or exchange, as the case may be.

The more time that elapses between the steps taken to qualify the partnership interest for an exchange and the disposition of the Relinquished Property, the less likely the IRS will challenge the exchange.  Dissolution and sale in separate tax years is desirable.

It is critical that the taxpayer (former partner) retain individual ownership of the Replacement Property for a substantial period of time.  The taxpayer should not form a partnership to own the Replacement Property shortly after the exchange.  The taxpayer should not contribute the Replacement Property to a partnership or otherwise dispose of the property shortly after the exchange.

It is best, whenever possible, for each Exchangor (former partner) to acquire a 100 percent interest in a Replacement Property.

If joint ownership is involved in the acquisition of the Replacement Property, care must be taken to avoid the appearance of partnership ownership of the Replacement Property.