Partnerships can be an efficient way for multiple investors to purchase commercial real estate. Combining capital often helps investors buy commercial assets that would be beyond their reach as individual investors.
However, partnership structures can be a bit problematic in a 1031 exchange, especially when one or more partners have opposing investment goals. Let’s examine how partnerships and LLCs can satisfy IRS requirements for a 1031 exchange, as well as how to handle partners that want to cash out their proceeds rather than defer capital gains taxes by completing a 1031 exchange.
Partnership Concerns During a 1031 Exchange
Partnership structures offer investors many strategic advantages outside of pooling their capital. Partnering can blend individual expertise, experience, and skills into a singular formidable force. Partnerships also tend to offer investors increased borrowing capacity, as well as potential tax benefits.
However, a partnership or LLC that owns commercial real estate is recognized by the IRS as a singular taxpaying entity. This entity can complete a 1031 exchange by relinquishing an existing asset and purchasing a like-kind replacement; however, the individuals within the entity cannot sell or dispose of their ownership shares because the IRS views partnership interests as personal property rather than real property. So despite the fact that the partnership holds ownership interest in real property, the shares within that partnership are not considered to be like-kind in the acquisition of real property by the IRS. Each partner holds a personal property interest in the joint investment asset rather than a direct ownership interest.
There are ways for investors in a partnership or LLC to still defer their capital gains liabilities through a 1031 exchange while allowing other partners to exit the investment at the partnership level. However, these processes can be quite complicated and require a great deal of advance planning.
Common Exit Strategies for Investment Partnerships
Partners who want to cash out and exit the partnership at the close of sale of an investment property have a few strategic exit solutions.
- Dissolution. The partnership can be dissolved. All parties would be subject to paying associated taxes.
- Buyout. Partners or new investors purchase the ownership interests of the departing party so the partnership can continue and complete a 1031 exchange.
- Drop-and-Swap. Partners convert their interests in the relinquished property into tenant-in-common shares for each partner. The exiting partner cashes out his or her shares (the drop), while the continuing partners (and same taxpaying entity) completes a 1031 exchange (the swap).
- Swap-and-Drop. The inverse of the above strategy. The existing partnership completes a 1031 exchange (swap), and after a certain time, the exiting partner cashes out (drop). The investment must be held for a certain length of time to avoid being challenged, however -- typically 24 months or more.
While it’s possible to buy out or cash out an existing partner, it’s usually a complicated process that requires a great deal of advance planning to ensure the exchange remains compliant with IRS guidelines. Investors who exit partnerships during or after a 1031 exchange will face capital gains and depreciation recapture taxes as well.
