Partnership like-kind exchanges: "Booting" the cash partner

A partnership is typically formed by persons who wish to unite to develop or own property that they could not afford to own or manage themselves. Occasionally, there is a disagreement among partners as to how an important issue should be handled such as the disposition of the major asset owned by the partnership. When it comes to the sale of real property held by the partnership, some partners may wish to reinvest the proceeds into a replacement property and defer the gain through a §1031 like-kind exchange, while others desire to receive the cash, pay their tax on the gain, and go their separate way.

If a like-kind exchange of real estate is planned within a partnership, some partners may wish to cash out of their investment or may want to exchange into a different property than the other partners do in the partnership’s §1031 exchange. There are four primary options to consider in order to successfully complete a §1031 exchange for the reinvesting partners when other partners want to be redeemed out. Although each option will have different tax and economic impacts on the partnership as a whole and the partners individually, the goal is to minimize the resulting taxable gain and the tax liability to the partners who want to defer the gain. These four options are highlighted below, and each of these options should be considered by the partners to determine the income tax impact and the economic feasibility of achieving their different objectives.

...the goal is to minimize the resulting taxable gain and the tax liability to the partners who want to defer the gain.

Options

1. The partnership exchanges the originally-owned property through a qualified intermediary for a new qualifying like-kind replacement property plus cash (taxable “boot”) in a §1031 exchange. The partnership could then specially allocate the taxable boot gain solely to the exiting partners who will receive the cash in redemption of their partnership interests. The question is will the IRS respect this special allocation of gain only to the partners who receive the cash?
2. The “drop and swap” strategy. The partnership would distribute a tenancy-in-common interest in the partnership’s real property to the exiting partner(s). This would allow the partnership and the exiting partners to either receive cash from the property purchaser or complete their separate like-kind exchanges. Will the partners do what may be necessary for the IRS to respect the “drop and swap” transaction?
3. Purchase the partnership interests (through a redemption or cross-purchase) of the partners who do not wish to reinvest into a replacement property. The sale of the relinquished property and acquisition of the replacement property would occur at the partnership entity. The key issue in this option is where the funds come from to buy out the partners who do not wish to be part of the like-kind exchange.
4. The partnership exchanges the originally owned property for cash plus buyer’s promissory notes that would initially be held by a qualified intermediary. The partnership would redeem the partnership interests of the partners who do not wish to participate in the replacement property by distributing the buyer’s promissory notes to them. The buyer would make payments on the promissory notes directly to the redeemed partners. The partnership would acquire the new replacement property through a qualified intermediary with the cash sale proceeds. If the partnership has a cooperative buyer, this option may have the most certain tax result.

In conclusion

Partnership like-kind exchanges can be complicated transactions, especially when partners want to go their separate ways. Each option described above has different tax consequences, economic feasibility concerns, and benefits to all of the partners involved. The partners will need to weigh these options to make the best decision from an economic and taxability outcome.