Real Estate Partnerships and Section 1031 Exchanges
In this article, Allen Matkins partner Jared Kassan focuses on the legal issues and solutions for real estate investors who wish to dispose of their property and utilize section 1031 of the internal revenue code. The case study focused on a fictional LLC with three owners, one of whom wants to leave the partnership. In the scenario, the LLC owns real property with a fair market value of $900, a basis of $300, and $0 debt. This article will start by explaining how the classic drop and swap might work. If you are in a real estate partnership and considering a Section 1031 exchange, review the scenarios outlined below to better understand the tax implications and advantages of each structure.
DROP AND SWAP
In this situation, the two partners who want to stay in the partnership own a two-thirds indirect interest in the property, and the partner who wants to leave owns a one-third interest. Using the drop and swap technique, the LLC and the third partner become tenants in common. This requires recognizing both parties as tenants in common and not a new partnership. They typically effectuate this strategy by transferring the appropriate tenant in common interest in the property to the third partner, signing a tenancy in common agreement, assuming loans and contracts, notifying tenants who will be receiving rent checks, and separating the books.
Although this transaction structure is common in much of the country, drop and swap structures are less common in California, where 1031 transactions face more scrutiny from the state taxing authority than in other states. When reviewing the tenancy in common structure, some of the things that the California taxing authority will focus on is whether the parties notified tenants of the change in structure, how far in advance of an eventual sale the tenancy in common relationship was put in place, and whether the buyer of the property was aware or consented to the seller creating a tenancy in common structure. California will often continue to challenge a “drop and swap” structure as a violation of the “held for” test under section 1031 despite taxpayer favorable case law on this issue. The below includes several alternatives to this type of structure that account for some of these issues and how they work.
1. PARTNERSHIP DIVISION
The partnership division solution requires the creation of a new LLC. In this case, with three partners, two may each retain 49% ownership of the original LLC and 2% ownership of the new LLC. The remaining partner has 2% ownership of the original LLC and 98% ownership of the new LLC. The original LLC also keeps 2/3 of the parcel, while the new LLC has 1/3, and each can separately pursue a 1031 exchange into replacement properties. Both of the partnerships are continuations of the prior partnership and should inherit the characteristics of the prior partnership, making it more difficult to challenge a section 1031 exchange as violating the “held for” test. Although there are no positive rulings on this structure under section 1031, there is a positive ruling under the similar section 1033 provision.
2. TRACKING UNITS
In this structure, the historical partnership LLC that has owned the property is the exchanger under section 1031. The LLC exchanges into multiple assets where different replacement properties are “designated” or “tracked” to specific partners. The idea is that with tracking units, the LLC is able to allocate a majority of the economic benefits and burdens of each property to the partners that desired that specific asset, while still sharing a material amount of the profits among the members to maintain a partnership. The key to this structure’s success is tracking and the debated question is how much of the economics the LLC members need to share. For example, a 10/90 split may work well in some circumstances. Still, the value of the property is an essential factor — note that 1% of a multi-million-dollar parcel may be sufficient to qualify as material interest.
3. SYNTHETIC “DROP & SWAP”
In a synthetic drop and swap, the LLC converts to a Delaware Statutory Trust (DST). The partners can sell their interests to the buyer and then choose to cash out or complete a 1031 exchange. Although the structure is set up to treat the beneficial interest holders of the DST as owners of undivided fractional interests in real estate for tax purposes, this structure is subject to different rules and restrictions than a typical tenancy in common structure. DSTs are subject to what many people refer to as “the seven deadly sins of DSTs,” which are actions that the trustee or manager of the DST are prohibited from taking. This includes refinancing, entering into leases, and redeveloping the property. However, it can be easier to convert to a DST than a state-law tenancy in common when a loan is involved, because a DST conversion does not necessarily need to involve a loan assumption in the same way a tenancy in common structure does. This type of structure works best with raw land and triple net leases.
If you are in a real estate partnership and considering a Section 1031 exchange and are unsure of the tax implications, contact your tax professional.
Thanks to Jared Kassan at Allen Matkins for contributing this article.
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