A 1031 exchange is a way of deferring capital gains taxes on the sale of real estate. Taxpayers who sell property held for investment purposes can defer the taxes by directing the proceeds from the sale into "like-kind" property of the same or greater value, also to be used for investment. In practice, almost any investment property has been considered “like-kind” by the IRS.
For example, an investor can sell a rental house and purchase an office building, or vice versa. Likewise, they can sell a retail property and purchase multi-family housing or sell self-storage units and buy an industrial facility. Despite the flexible interpretation of this aspect of the code section, the IRS is not as generous concerning the other portions, which have tight deadlines and qualifications. The requirements for a 1031 exchange include the following:
- The investor must not have access to the proceeds from the sale of the relinquished property during the time between the sale of that property and the purchase of the replacement property or properties. That's one reason why using a Qualified Intermediary is essential to manage the transaction. The QI holds the funds, oversees the accounting, and administers other crucial aspects of the exchange.
- The investor must adhere to strict timelines established by the tax code. For example, taxpayers must identify potential replacement properties within 45 days of the initial sale and complete the exchange within 180 days. The QI handles these transactions.
Can Partners Exchange Property Through a 1031 Exchange?
If investors hold property as a pooled interest through partnership, the assets are owned by the partnership, not by the partners. Owning real estate within a partnership may have certain advantages since the partnership structure can protect individual partners. In addition, the partnership typically passes the income tax liability through to the individual partners. Also, pooling capital or borrowing capacity may allow investors to reach their ownership goals.
However, according to the IRS, the partnership interests are personal property and not considered "like-kind" to real estate. As a result, a partnership can transact a 1031 exchange. Still, the individual partners can't exchange their property shares for other "like-kind" assets because their partnership shares are not real estate assets.
What Is the Best Strategy for a Partner Wanting to Exit?
The most straightforward approach when partners have diverging goals is to dissolve the partnership and sell the shared asset. Each partner would be responsible for the taxes due on their share. If only one or a small number of partners wants to leave, it's possible that the remaining partners can buy out the ones wishing to depart. Departing investors would pay taxes on their shares.
If the partnership is pursuing a 1031 exchange while one or more partners are exiting the partnership, the transaction becomes more exposed to IRS scrutiny. Therefore, it is better to wait 24 months after completing an exchange before leaving a partnership.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits.