Drop & swap: Like-kind exchange tax planning
In order for a disposition of property to qualify for Section 1031 like-kind exchange treatment with no gain or loss recognition, the exchanged property and the replacement property are both required to be held for productive use in a trade or business or for investment by the taxpayer doing the exchange, and 100 percent of the sale proceeds need to be reinvested in the qualifying like-kind replacement property.
In the case of property held by a partnership, the partnership is considered the taxpayer in the exchange transaction — not the partners themselves. Statutorily, like-kind exchange treatment is not available for exchanges of partnership interests. Therefore, when some, but not all, of the partners want to reinvest their shares of the sale proceeds and obtain like-kind exchange treatment, those partners desiring an exchange typically will need to hold undivided interests in the property through a tenancy in common arrangement. This arrangement allows individual owners of the property to determine whether to do a like-kind exchange, defer their share of the gain, and to select their own replacement property.
It’s important to meet certain practical and IRS-specified conditions when establishing a tenancy in common. In Revenue Procedure 2002-22, the IRS provides the criteria that it will require in order to provide a private ruling request to taxpayers who want assurance that their co-ownership of rental real property will be treated as a tenancy in common. Although the vast majority of property owners won’t request such a private letter ruling, this Revenue Procedure does provide the criteria that should exist in order to have confidence that this co-ownership arrangement will be treated as an ownership interest in real property and not be treated as an ineligible partnership interest for income tax purposes.
In addition to the IRS requirements that should be present in these tenancy in common arrangements, the following economic considerations need to be addressed carefully:
- Loan covenants.
Loan documents will need to be reviewed to ensure no covenants will be violated by the distribution of the property and establishment of a tenancy in common arrangement.
- Debt allocations.
Debt secured by the property will need to be allocated to each member proportionately in accordance to their undivided interests in the property. Therefore, if only certain members guarantee the debt while the property is owned by a partnership or multiple-member LLC, they will lose their preferential recourse debt allocation to the extent a portion of the debt is reallocated to a non-guarantor co-owner.
- Timing for establishment of tenancy in common.
The tenancy in common arrangement should be established as early as possible, preferably before any specific negotiations begin with potential purchasers for the sale of the property. It is always better if the tenant in common arrangement is established in a different tax year than the sale of the property is made.
- Disproportionate capital accounts.
Capital accounts can become disproportionate for a variety of reasons during the existence of the partnership or LLC. However, a tenancy in common arrangement does not allow for the disproportionality and, therefore, this difference between the partnership interests or sharing ratios and owners’ capital account balances will need to be resolved prior to the establishment of the tenancy in common interests.
- Ownership of tenancy in common interests.
It’s recommended that each owner’s undivided interest in the property be held through a single-member LLC, which is disregarded for federal income tax purposes. This will provide better legal liability protection for the co-owners.
- Distribution of property to some partners.
A tenancy in common can be created between the partnership and certain partners of the partnership by distributing undivided interests in the property to only certain partners (e.g., those who do not wish to engage in the like-kind exchange). However, this could impact the economics of the deal, so further analysis would be required in this circumstance.
- Profits interests or distribution waterfalls.
Under a tenancy in common arrangement, profits interest members are not permitted nor are any special allocations of cash flow or sales proceeds because of the essential proportionate ownership requirement in Revenue Procedure 2002-22.
Plante Moran can assist you in addressing these like-kind exchange tax planning and economic concerns to give you the best chance of having your exchange respected by the IRS. For more information, give us a call.