1031 Exchange Restrictions on Partnerships
Partnerships take many forms. There are general partnerships, limited partnerships, joint ventures, joint tenancy, Corporations, LLCs, etc. The IRS recognizes a partnership as a single entity, a single person. This "person" may exchange real estate, but the individuals who make up the partnership may not exchange their individual shares. This creates a problem when one or more persons wish to break out of the partnership and go on their own without paying capital gains tax. The only exception to this restriction is if ownership is held in tenancy-in-common (TIC) because the IRS will consider that each owner holds the equivalent of a separate piece of real estate and can trade that piece for another property of their own.
Many investors are in a partnership or wish to enter one that is already formed. If their partnership is not a TIC, it may be possible to convert. General partnerships and joint ventures may be converted with little problem. Limited partnerships, corporations and the like cannot usually be converted.
The conversion of the partnership to TIC allows the investor to accomplish the desired exchange. There are two basic solutions to navigate, each with its own benefits and pitfalls.
Drop and Swap
The drop and swap approach describes an exchange where a partnership interest is converted to TIC before the exchange takes place. The question of timing is the largest issue in this technique. Members of the partnership have two options in dissolving the partnership prior to the exchange taking place:
- Convert the property from partnership to TIC at least a year in advance.
- Convert the property from partnership to TIC in escrow.
Swap and Drop
The swap and drop approach describes an exchange where a partnership interest is converted to TIC after the exchange takes place.
Partnerships are formed for different reasons, and that is why there is so much variety. Each form of partnership has advantages and disadvantages that should be reviewed by a qualified attorney. The attorney can help determine whether it is possible to convert a particular form of ownership and when to do it.
A great deal of confusion and misinformation is generated by partnership exchanges. If you intend to invest with others, TIC ownership structure is the preferred form of partnership because it allows the individual investor the ability to exchange into and out of particular investments while utilizing section 1031.