Accommodating the competing objectives of one partner who wants his partnership to engage in a taxable sale of real estate and another, who wants the entity to engage in a like-kind exchange, presents a tax dilemma. Although the IRS has not condoned this hybrid tax result, neither has it precluded it. Accordingly, various tax strategies have evolved.
One method involves distributing undivided interests in the relinquished property to the partners. The partner cashing out would sell his undivided interest, while the other partner would swap his undivided interest for other real estate in a qualifying like-kind exchange. This strategy should succeed, since (i) distributions of partnership property are generally not taxable events and (ii) there is no prohibition against exchanging an undivided interest in one property for total ownership of another. Nevertheless, the IRS could argue that partnership interests were, in substance, being exchanged, in violation of § 1031(a)(2)(D), which expressly excludes partnership interests from qualifying for like-kind exchange treatment.
The IRS could also argue that the distribution of undivided interests followed immediately by an exchange violates the requirement of §1031(a), i.e., that the exchanged property “be held for productive use in a trade or business or for investment” immediately before the exchange. Finally, the distribution of undivided interests under state law could be treated as the distribution of partnership interests if, after the exchange, the entity continued to engage in nonpassive activities, such as the active management of real estate.
In the second method, the buyer purchases the partnership’s property for a mix of cash and an installment note. The cash portion is paid to a qualified intermediary and a typical § 1031 exchange ensues with respect to that part of the consideration. The portion of the consideration represented by the installment note is transferred directly to the partnership, which then distributes it to the partner wishing to cash out in redemption of his partnership interest. The note would typically provide for payment of 99 percent within a week, and 1 percent in the following year.
This method apparently generates a good tax result since (i) no gain is recognized by the partnership on receipt of the installment note; (ii) installment reporting of gain should be available under § 453, since payment occurs over two years; and (iii) the “qualified use” requirement is met since the partnership has (presumably) not acquired the property immediately before the exchange.
May replacement property be transferred to a partnership after a like-kind exchange without violating continuity of investment? While Rev. Rul. 75-292 barred exchange treatment where a transfer was made to a wholly-owned corporation immediately following an exchange, the 9th Circuit in Magnesson found § 1031 satisfied where replacement property was contributed to a partnership following an exchange. Magnesson reasoned that the property was held for investment, no cash or non-like-kind property was received, and ownership in the replacement property continued, albeit indirectly.
The ABA view is that the transfer of property to or from a partnership before or after a like-kind exchange should not violate the “qualified use” requirement, since the proper standard should be the absence of taxpayer intent to either liquidate an investment in the subject property or use the property for personal use.