Partnership Issues in a 1031 Exchange: More Options

PART II: Options When Advance Planning is not Possible
(This concludes our two-part series with relevant information for real estate investors involved in partnerships. See our last installment discussing options for investors when advance planning is possible.)

If distributing an undivided interest of the partnership property or dissolving the partnership well in advance of the exchange is not possible, the partners who want to exchange have the following options at their disposal as well:

Purchase the interest of a retiring partner: This technique can be implemented before or after a §1031 exchange. If done before the exchange, the partners who want to exchange contribute additional equity which is used to buy out the retiring partner(s). The smaller partnership then enters into an exchange. The partnership must acquire Replacement Property which has the same or greater value compared to the Relinquished Property to fully defer taxes. If the partner buy out occurs after the exchange, the partnership typically refinances the Replacement Property received in the exchange to generate the cash necessary to buy out the retiring partner(s).

Sell the Relinquished Property for cash and an installment note: Under this method, the buyer of the Relinquished Property purchases the property with both cash and an installment note. The cash is used by the partnership in the exchange and the retiring partner receives the installment note in redemption of their partnership interest. If at least one payment is made in the following tax year, it should be considered a valid installment note and receive installment sale treatment under I.R.C. §453. Most tax advisors suggest that at least 5% of the total payments of the note be made in the next tax year.

Both of the above options (as well as distributing an undivided interest to a retiring partner) require that after the buy-out or redemption, there must be at least two remaining partners who owned more than 50% of the partnership to avoid a technical termination of the partnership and ensure that the partnership continues to exist to satisfy the “held for” requirement.

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