Partnership Interests In Section 1031 Exchanges
1031, or like kind exchanges are commonly used by investors as a means to “trade up” their investments while deferring capital gains taxes. It’s quite a sound investment strategy as it allows you to continuously trade up your investments so their values grow without creating tax penalties that cut into those profits along the way. However, there are some risks involved when you bring partnerships into the matter as different partners have different expectations, needs, and financial goals.
Partnerships are an excellent means to combine resources in order to come up with the capital to make savvy real estate investments in the first place. However, the IRS has very specific requirements regarding partnerships and 1031 exchanges. Learn the facts before diving into a partnership to maximize your potential for success.
Plan an Exit Strategy before You Strike the Bargain
Planning is always the best course of action. If you have a plan for a graceful exit from the partnership should one partner need to do so quickly, you’re not left scrambling to try to make a safe exit from the partnership when the need arises.
Unfortunately, most people entering into a partnership are focused on successful outcomes and don’t take the time to consider things like divorces, moves, and other life changes forcing one partner to liquidate assets and/or investments – leaving the remaining partners with a bit of a dilemma on their hands.
What You Should Not Do When a Partner Desires to Exit the Partnership
The simplest solution, in the eyes of many investors, would be to simply “buy out” the partner who wants to leave. It might seem like the most advantageous option available to you, but it’s rarely a good move to make.
This is especially true if the remaining partners must refinance the original property in order to generate the funds needed for the buyout. The IRS views this is a completely new real estate transaction and may consider it a step transaction disqualifying it as a 1031 exchange. This leaves the remaining partners holding the bag for capital gains taxes and greater debt, which many find unappealing.
Consider the value of the following as exit strategies so that the remaining partners are able to reinvest, or “trade up” according to the original plan –without a tax penalty. These plans, when put into play properly, can help investors participating in the 1031 exchange the tax deferment. However, the partner who cashes out will be required to pay taxes on the money earned in the deal.
Drop and Swap
The Drop and Swap technique involves reorganizing the partnership so that each owner owns a percentage of the property in the period before an exchange. Then individual owners are able to pursue their own investment goals rather than acting as a partnership. The remaining partners can “exchange the property” and defer taxes while partners interested in cashing out are free to do so.
While the IRS does not define a specific amount of time to prove the intent hold, the longer your hold time for the property is, the better your case may be if the question does arise. If the transaction takes place too quickly, the IRS may argue that you acquired the property for the sole intent of selling the property disqualifying you from the tax deferring benefits of an exchange.
Be warned though, that a poorly executed attempt could result in charges of tax fraud. Do not attempt this without the assistance of a trustworthy tax advisor. It is wise to make this part of your investing strategy from start to finish, but especially with investments that have tax implications that are potentially this significant.
Swap and Drop
The Swap and Drop technique reorganizes the partnership, much the same as a drop and swap. This time, the renaming occurs only after the exchange is made. The “renaming,” in this situation can only be done after a sufficient period of time has passed with the partnership owning the property in order to meet IRS rules regarding the Internet to hold so that the property qualifies for treatment as a 1031 exchange property.
24 months is the general recommendation for holding an exchanged property before distributing it though there is no specific date established by the IRS at this time. Once again, it’s strongly urged that you work with a trusted tax professional in order to make sure that every aspect of this is done in accordance with current tax laws and regulations.
There are other options available, though many consider these to be the simpler, and more commonly practiced among the available options that allow you to comply with IRS standards while still enjoying the investment benefits 1031 exchanges provide.