What happens when one partner says no to an exchange?

By far, the most frequent question I receive today about tax deferred exchanges is "May the partners or members of a partnership or LLC taxed as a partnership perform a [section]1031 tax deferred exchange if not all of the partners/members want to exchange or if all partners/members want to exchange independent of one another?"

The reason for the frequency of the question is two-fold. First, for at least the last two decades, the most popular form of real estate ownership when multiple investors are involved has been that of an LLC or partnership for many reasons, including the ability to avoid double taxation and to limit one's exposure to personal liability.

Thus, there are presently a very large number of investors owning property in the name of a multiple member LLC or partnership. Second, these investors have significant gain in their real estate investments due to the great appreciation in most real estate markets today. Consequently, these investors naturally perform 1031 exchanges as a way to defer the payment of capital gain taxes on the sale of their investment property.

However, for several reasons, investors cannot use a tax deferred exchange to sell their respective partnership interests independently of the partnership and use the proceeds to reinvest in other real estate in a [section]1031 exchange.

First, the Internal Revenue Code specifically excludes partnership interests from tax deferral in an exchange. Second, individual partnership interests are considered personal property even if the partnership holds title to real estate at the entity level.

One requirement of [section]1031 is that an investor must dispose of and acquire "like-kind" property, and personal property is not "like-kind" to real property.

Thus, an investor owning a partnership interest will not be able to benefit from a [section]1031 tax deferral unless either the entire partnership is willing to perform an exchange or the investor is able to restructure the partnership in such a way as to convert his partnership interest into that of a tenant-in-common.

Restructuring a partnership to convert former partners to tenants-in-common and then performing an exchange is sometimes referred to as a "drop and swap".

Generally speaking, the partnership distributes the assets of the partnership, the real estate, to the partners pro-rata by deed. The result is that each of the former partners now own an undivided pro rata interest in the real property formerly owned by the partnership.

The partnership generally elects out of the partnership under IRC [section]761 and thereafter dissolves. The investors should ensure that their actions thereafter are consistent with those of tenants-in-common and not of partners.

Presuming all of the above are properly accomplished, the investors' interests will have been converted from those of partners to those of tenants in common with each investor owning a direct interest in real property which has the potential to be exchanged for another real property interest under [section]1031.

However, in most cases, investors seek to restructure partnerships when they are on the verge of selling the real estate.

If the property is exchanged shortly after the partners have become tenants-in-common, there is a risk in the event of audit that the exchange will be overturned.

The IRS may take the position that even though the partnership at the entity level held property for investment purposes, the individual investors did not hold title to their respective interests as tenants-in-common sufficiently long enough to qualify as having held such interests for investment purpose and, in fact, acquired their respective interests as tenants-in-common solely for purposes of selling the property.

The investor's advisors may attempt to argue, based on dicta in certain cases, that they should be able to tack on their holding period as partners to their holding period as tenants-in-common to establish a long term holding period and the requisite investment intent.

However, the issue is unsettled as the few tax court decisions to address the issue have been contradictory and there is not much in the way of formal guidance on these issues.

Thus, it is recommended that investors interested in restructuring their interests do so as far in advance as possible (many tax and legal advisors recommend holding title to the property as tenants-in-common for a year or more before the sale of the relinquished property) and ensure that the restructure is completed before any contract for sale is signed so that it is signed by the tenants-in-common, rather than the partnership.

There are additional issues to consider where any restructure is contemplated, whether before or after an exchange, and thus competent legal and tax advisors should always be consulted.

There also may be costs related to the restructure about which investors should be aware before taking steps to convert their ownership structure to that of tenants-in-common.

Among other costs, there may be transfer tax assessed upon the deeding of the property from the partnership to the investors as tenants-in- common. Certain jurisdictions may exempt such transfers from taxation under one or more applicable exemptions. If that is not the case, transfer tax should be considered in evaluating costs of the transaction.

In addition, some investors may find that the restrictions inherent in operating as tenants-in-common, such as no preferred position regarding profits, no ability of co-investors to prohibit the sale of another's interests with limited exception, equal voting rights etc. may lead to undesirable operating results.

This, too, should be considered by all investors in evaluating the costs versus benefits of restructuring a partnership in order to perform independent exchanges.

This information is not intended to replace qualified legal and/or tax advisors. Every taxpayer should review their specific transaction with their own legal and/or tax counsel.

BY PAMELA A. MICHAELS, ESQUIRE

NORTHEAST DIVISION MANAGER

ASSET PRESERVATION, INC.