Planning Ahead When Partners Want to Go Their Separate Ways
When a partnership is selling property and some, but not all, of the partners want to do an exchange, it creates complications for the exchange. A basic rule of exchanges is that the taxpayer who disposes of the relinquished property must be the same taxpayer that acquires the replacement property. If the partnership sells the relinquished property, then the partnership, and not an individual partner, must buy the replacement property. In addition, Section 1031 does not apply to an exchange of partnership interests, so a partner cannot dispose of his partnership interest as relinquished property in an exchange.
If the partners don’t want to keep the partnership intact, one solution to this problem is the drop and swap, where the partnership is dissolved, the property is deeded down to the individual partners as tenants-in-common, and then each individual partner can choose to either cash out and pay the taxes or trade into a replacement property.
The benefits of a drop and swap are that the individual owners now each own a real estate interest that can be traded into other real estate. In addition, because of partnership tax rules, the transfer of the partnership property down to the partners should be a tax free transfer.
Because of these benefits, drop and swaps are fairly common, but they are not without risk. The IRS and the California Franchise Tax Board have challenged drop and swap transactions based on the argument that the true selling party is the partnership, not the individual partners. In addition, it may be difficult for the partners to establish that they held the relinquished property for investment purposes, which is required under Section 1031. In most cases, the partners own the relinquished property for a short time before the sale, so the IRS may argue that they owned it with the intent to sell it rather than the intent to hold it for investment purposes.
Some tax advisors recommend planning ahead and completing the drop well ahead of the closing. To make that work, the deed or deeds should be recorded and the former partners should treat the arrangement as a tenancy-in-common rather than a partnership. In any event, a drop and swap is a complicated transaction with a number of tax implications and a tax advisor should be consulted.