Real Estate Partnerships and Section 1031 Exchanges

Allen Matkins partner Jared Kassan participated on a panel earlier this year to discuss legal issues surrounding partnerships and 1031 exchanges. The panel began by discussing the traditional “drop and swap” strategy with its associated issues and then went on to discuss alternatives. The panel 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. Panelists started the conversation 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 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 panel offered several alternatives to this type of structure that account for some of these issues and how they work. Here are some of the novel 1031 exchange structures they discussed.

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 not 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. Panelists agreed that a 10/90 split works well. Still, the value of the property is an essential factor — noting that 1% of a multi-million dollar parcel may be sufficient to qualify as material interest.

3. Payment Installment Note

When one partner wants to cash out and is not interested in a 1031 exchange, the LLC may be able to use what’s called a payment installment note solution (PINs). In this structure, the Qualified Intermediary (QI) signs two documents: a 1031 exchange for the partners remaining in the LLC and a note for the partner who wants to cash out. Within 30 days of closing, the cash-out partner receives 90% of the funds. The remaining balance is paid by January 2 of the following year. One consideration with this structure is whether the debt must be covered and the loan must be secured. California taxpayers should exercise caution when trying to utilize this structure because California’s state taxing authority has indicated they will challenge these transactions.

4. 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 or would like to discuss which structure might be most advantageous, contact Jared Kassan or the Allen Matkins attorney with whom you normally work.