O ne of the requirements of a 1031 exchange is that the entity that sells the relinquished property must be the same entity that acquires the new or replacement property. Where the property is owned by a partnership or a limited liability corporation (LLC) with multiple partners, the partnership or LLC is viewed as the exchanging entity.

 

A common question posed to our company involves sales of property where the partners want to do an exchange, but they no longer want to be partners with each other. Let’s take as an example the OLDMEN Partnership, in which Hesh and Harryeach owned an equal interest in the partnership. This partnership had entered into a Agreement to Sell the relinquished property.

 

Hesh and Harry wanted to stay invested in real estate and decided they wanted to do a 1031 exchange, but would like to part ways. Can a 1031 exchange be completed if the partnership is required to do the exchange as an entity?

 

Some experts would suggest that the partnership be dissolved before closing and that a deed reflecting a 50/50 tenancy in common interest be recorded.

 

The problem with this idea is that it violates the rule of 1031 exchanges that requires the exchange property be held as an investment, rather than held for resale. This rule requires a holding period of at least a year and a day. When the partners transfer ownership from the partnership to each of them, they start their year and a day holding period over again.

 

Thus, if any of the partners get audited, the IRS most likely will argue that they have not owned their property for investment, but for resale since their holding period starts over when the taxpayer owning the property
changes from the partnership to each partner.

 

The other option is to have the partnership buy two new properties and after a year and a day then dissolve the partnership.

 

This approach has some problems. Since the partners would buy the replacement property with the intention of eventually dissolving the partnership and distributing the properties out, they would not want a loan and mortgage that blankets the two properties. The best way to solve this problem would be to use the same lender on each replacement property and to get the lender involved in the plan from the beginning so that at the dissolution of the partnership the loan guaranties may be dropped on each of the properties owned by the partners not ending up with the property.

 

Of course, most lenders will want to earn fees for doing anything out of the ordinary. And there could be state transfer taxes incurred by the transfer of the property from partnership to partner.

 

It will take some tax planning and maybe time to resolve some of the partnership issues that may prevent an individual from taking advantage of the benefits of a 1031 Exchange.