A common question that arises regarding an Exchange under IRC §1031 involves an Exchange by partners of a partnership, beneficiaries of a trust or members of a limited liability company. The answer is not always straightforward, simple, conclusive or without risk. However, some facts are known.
Taxpayers have tried several ways to circumvent the prohibition against Exchanges of partnership and beneficial interests. The most common being, electing to convert their non-qualifying interests into a qualifying interest such as a tenant in common interest.
For example, assume Jack and Jill are partners in a general partnership. The partnership is selling its sole real estate asset. Jack wants to Exchange his interest for other qualifying property under IRC§1031 while Jill desires to sell for cash.
Prior to the sale, Jack and Jill elect to dissolve the partnership and distribute the real estate to themselves as tenants in common. Their intent is that their tenant in common interest will now qualify for individual treatment. Jack can Exchange his interest and Jill can sell her interest in a concurrent transfer to a buyer.
Is Jack’s transaction valid? Can Jack Exchange his undivided tenant in common interest? In general, the disillusionment of the partnership and distribution of the partnership assets to Jack and Jill individually as tenants in common does not constitute a taxable transfer. However, has Jack held his tenant in common interest in the property in such a manner that it will qualify for an Exchange?
The real issue to consider is whether or not the transfer of the property to the partners as tenants in common and the subsequent Exchange by Jack will be deemed to be a step transaction which, if applicable, would certainly amount to an Exchange of a partnership interest for a fee interest by Jack and not qualify for non-recognition treatment under IRC §1031.
To overcome the threat of the step transaction, Jack and Jill should:
- Transfer the property out of the partnership well in advance of the Exchange. If the partnership made the transfer to Jack and Jill a year in advance of the date of Jack’s Exchange and prior to any pending knowledge of the sale then there should be sufficient evidence that the transfer and the Exchange are not related transactions for purposes of applying the step transaction doctrine.
- The partnership agreement between Jack and Jill should recite that Jack and Jill hold their respective interest either for investment or for the productive use in a trade or business. This recital would help to establish a continuation of a qualifying holding upon the transfer to Jack and Jill as tenants in common.
- The partnership agreement may also want to recite that Jack has the sole and absolute authority to direct the actions of the partnership with respect to the conveyance of his interest, that Jack and Jill are each solely responsible for reporting their share of income and expenses and that they each have sole responsibility for the management of their interest in the property.
- The Exchange should be reported by Jack on his individual tax return. For the tax year of the Exchange, at least, each party should report his or her pro rata share of the operating income and expense from the property directly to their individual Form 1040, Schedule E, Part 1. The partnership should not file a partnership information return with K1’s to Jack and Jill.
- The purchase and sale agreement and closing documents for the property should show the sellers as Jack and Jill individually and not Jack and Jill as general partners of the partnership.