Because commercial real estate assets are so expensive to purchase, they are rarely purchased by a single, individual investor. Instead, they are typically purchased through structures that allow individual investors to pool their money together so they can afford larger, higher quality properties. One of the most common structures through which this is accomplished is a partnership. While there are a number of benefits to purchasing a property through the partnership structure, there can also be a number of complications, particularly when it comes time to sell the property.
In this article, we are going to discuss partnerships, with a specific focus on whether 1031 Exchanges are allowable within this type of real estate ownership structure. In doing so, we will describe what a partnership is, what a 1031 Exchange is, whether one is allowable in a partnership, and the risks and benefits of this approach. By the end, readers will have the information needed to determine if this type of real estate transaction is a good fit for their individual circumstances.
At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers. In doing so, we frequently help investors with the placement of their 1031 Exchange funds. If you are an Accredited Investor and would like to learn more about how we can help with a 1031 Exchange, click here.
What is a Partnership?
According to the IRS, a partnership is a “relationship between two or more people to do trade or business. Each person contributes money, property, labor or skill, and shares in the profits and losses of the business.” In a real estate context, partners often come together to purchase and manage a property (according to the partnership agreement) that they likely could not afford on their own. In this sense, it is similar to a Limited Liability Company (LLC) ownership structure.
There are a number of benefits to this approach, such as the ability to purchase a higher quality property, ability to divide management responsibilities, and the income tax treatment of this structure.
What is a 1031 Exchange?
A 1031 Exchange, sometimes called a Like Kind Exchange, is a type of commercial real estate transaction that allows individual investors to defer capital gains taxes on the profitable sale of an investment property. Here is how it works
An investor identifies a property that they would like to sell, this is known as the Relinquished Property. They hire a real estate broker and, ideally, they are able to sell the property for more than they paid for it. When they do, this is known as a taxable gain.
However, capital gains taxes can be deferred as long as the sales proceeds are reinvested into another property (the Replacement Property) that is considered to be “like kind.” As a general rule, most commercial real estate is like kind to other commercial real estate.
To complete this transaction and receive full tax deferral, there are a number of rules that investors must comply with. Of note, there are three:
- Investors have a 45 day period of time, from the sale of the Relinquished Property, to identify a suitable Replacement Property.
- Investors have 180 days from the day the Relinquished Property is sold to complete the purchase of the Replacement Property.
- Perhaps most importantly as it relates to the topic of this article, the taxpayer on the title of the Replacement Property must be the same as the taxpayer on the title of the Replacement Property.
In theory, the property title rule is fairly straightforward. But, real estate partnerships can have dozens of people, all of whom have competing financial interests which can bring additional complexity to this transaction.
Complications of Partnership 1031 Exchanges
Given the specifics of the partnership structure, there are a number of factors that bring added complexity to a 1031 Exchange. They include:
The key structural issue with a 1031 Exchange is that a partnership consists of many different individuals, each of whom hold a partnership interest in the ownership entity. Each of these partners may have different financial goals and requirements. So, it is very common for some partners to want to do an exchange while others do not.
Potential Tax Risk
One of the benefits of the partnership structure is the tax treatment of it because it avoids the double taxation of a corporation. But, when some partners want to cash out their interest while others do not, it can create a taxable event for all partners.
Ownership of The Property
Again, 1031 Exchange rules require both the Relinquished Property and the Replacement Property to have the same title. This can be particularly challenging if there is even one partner who does not want to enter into the exchange because it could trigger a change in the title.
But, all is not lost with these partnership complications. There are a number of methods that a partnership can complete a 1031 Exchange – even with these complications.
Methods for Partnerships to Perform a 1031 Exchange
Every real estate partnership and transaction is unique so investors/partners must take the time to study the unique aspects of the transaction to determine which of the following exchange methodologies is most suitable to complete a 1031 Exchange
Exchange by the Partnership Itself
If, and this is a big if, all partners agree to the 1031 Exchange then the easiest and most straightforward way to do it is to title the Replacement Property the same way as the Relinquished Property. For example, if XYZ Partnership owns the Relinquished Property then the same partnership, XYZ Partnership, could buy the Replacement Property. All partners stay the same in this real estate transaction.
Exchange Post Distribution
In this scenario, a partnership can achieve tax deferral if they distribute real property to each of the partners based on their pro rata share of ownership (under section 731, a partnership distribution is considered to be tax free). Once the distribution is complete, the real estate partnership is dissolved.
Following the completion of the distribution, the partners can collectively enter into an agreement with a third party to sell the property while reserving their right to complete an exchange of their partnership interest individually by assigning their interest to a Qualified Intermediary.
If all of the partners want to complete a 1031 Exchange, but can’t agree on which property to acquire, they can complete a 1031 Exchange prior to distributing the partnership interest to its members. Here is how it works.
At the partnership level, there could be an agreement to enter into a 1031 Exchange transaction that includes multiple Replacement Properties that are agreeable to the respective partners. Once the purchase of the properties is complete, the partnership can distribute them to its partners who can either keep them or sell them in a taxable event.
Drop and Swap
Before selling the Relinquished Property, the partnership can distribute the property to each of its partners in proportion to their share of ownership using a tenancy in common interest ownership structure. Once complete, individuals will own a fractional share of the property rather than owning a share in a partnership that owns the property. The distinction is subtle, but important for legal purposes. This is the “drop.”
Once the distribution is complete, individual partners/shareholders are free to go their separate ways with regard to the property – including exchanging their interest in a 1031 Exchange. In such a scenario, they work with another individual looking to join the Tenants in Common ownership structure and “swap” their interest.
Partnership 1031 Exchanges and Real Estate Syndications
A “syndication” is a structure that is commonly used in real estate transactions and it allows individual investors to buy a fractional share of an institutional grade asset and hold it for investment purposes. This structure is frequently used to allow investors with a partnership interest to complete a 1031 Exchange.
In several of the examples above, the key to completing the exchange is a Tenancy In Common (TIC) ownership structure in which a “tenant” owns a fractional share of a property. And, they are allowed to sell or exchange this tenancy in common interest , which can be very helpful when trying to complete a partnership 1031 Exchange.
As a private equity real estate firm, one of the things that we do to help complete a partnership 1031 Exchange is that we can find a property and help set up the tenancy in common ownership structure and work with investors to use this structure to place their 1031 Exchange proceeds. In addition, we can manage the property for the partners/co-owners, which can make it a passive investment for them.
The key to completing this type of activity is advance planning and the input of tax advisors to make sure that all of the necessary rules are being followed. If they aren’t, the partner(s) may have to pay tax on any proceeds received when they file their tax return.
Summary of 1031 Exchanges for Partnerships
A partnership is a common real estate ownership structure that allows individual investors to pool their capital for the purchase of a real estate investment property.
A 1031 Exchange is a type of real estate transaction that allows investors to defer capital gains taxes on the profitable sale of an investment property.
As defined in the Internal Revenue Code (IRC) exchanges of partnership interests are not permissible in a 1031 Exchange. But, there are a number of ways that this can still be done including a drop and swap and pre/post exchange distribution of the partnership interests.
Using a Tenancy in Common ownership structure, private equity commercial real estate firms can assist individuals and partnerships with the placement of their 1031 Exchange funds.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We utilize our liquidity and decades of experience to find multi-tenanted, world-class investment opportunities for our partners.
If you are an Accredited Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.