Overcoming Section 1031 Exchange Hurdles

Partnerships and limited liability companies (LLCs) are excellent structures for owning and operating property, but they can present challenges when it comes time to sell, particularly if the partners wish to go their separate ways but also want to defer taxes through a Section 1031 exchange.

At closing, exiting partners are not able to simply take their individual profits and proceed to do their own Section 1031 exchanges. Further, distributing proceeds to exiting partners at closing can jeopardize the partnership’s ability to defer taxes.

Here, we explore various strategies that can help partners achieve their investment goals while reducing tax liabilities with the framework of a Section 1031 exchange.

Distributing an undivided interest

One common approach is distributing an undivided interest in the relinquished property to partners who wish to “cash out.” This approach involves distributing the partnership interest in the form of an undivided interest prior to the sale.

At closing, the adjusted partnership and former partners convey their interests to the buyer, with the former partners receiving their share of the cash proceeds. This technique can reduce the risk of the exchange being disallowed, especially if the transaction is completed well in advance of the sale.

Liquidating the partnership and distributing tenancy-in-common interests

Another strategy is to liquidate the partnership and distribute tenancy-in-common interests to each partner. This transaction should be completed prior to the property being listed for sale to avoid complications.

If the distribution occurs too close to the Section 1031 exchange, it may be challenged by taxing authorities. Establishing a valid tenancy-in-common ownership is crucial.

“Drop and swap” and “swap and drop” methods

Historically, “drop and swap” and “swap and drop” transactions were used to separate partners. In a “drop and swap,” the partnership distributes the relinquished property shortly before the exchange, while in a “swap and drop,” the distribution occurs shortly after.

These methods may be considered aggressive and could be challenged by taxing authorities, as the partnership’s holding period is not directly attributable to the individual exchanger.

Purchasing the interest of a retiring partner

This technique can be implemented before or after a Section 1031 exchange. If done prior, the remaining partners contribute additional equity to buy out the retiring partner, allowing the partnership to proceed with the exchange. If done after, the partnership refinances the replacement property to generate the necessary cash. Both methods require at least two partners to remain in the partnership after the buyout.

Selling relinquished property for cash and an installment note

In this approach, the buyer of the relinquished property pays with a combination of cash and an installment note. The partnership uses the cash portion for the Section 1031 exchange, while the retiring partner receives the installment note as redemption for their partnership interest. To qualify as an installment note under Section 453, at least one legitimate payment should be made in the following tax year.

How we can help

A well-structured Section 1031 exchange plan can help you identify suitable replacement properties, adhere to strict timelines, and navigate complex tax implications. Our experienced advisors can provide the necessary guidance to execute a successful 1031 exchange strategy.