Category: 1031 Exchange General

Can a partner or member trade their share of a property interest upon sale?
One of the most common questions asked of a qualified intermediary involves the situation in which one or more members or partners in a limited liability company (LLC) or partnership wish to do a 1031 exchange and others simply wish to cash out. There are several practical difficulties in this regard starting with Section 1031 itself.  The section generally provides
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged for property of like kind which is held for productive use in trade or business or for investment”.
However the section also provides for several exclusions to the ability to trade any qualified use asset and one of those exclusions states “This subsection shall not apply to any exchange of interests in a partnership.”  As a result, the challenge here is to allow members to go their separate ways while not deeming them attempting to trade in their capacities as members. 
While there are multiple ways to structure transactions allowing various members to effectively trade their interest, by far the most common technique is for the outgoing member to have the LLC redeem the member’s interest and to convey by deed the applicable percentage interest in the property equivalent to the member’s former share.  The transfer to the member and the subsequent trade by that person is generally referred to as a “drop and swap.”
How is a 1031 drop and swap done?
A 1031 like kind exchange rules, a taxpayer’s holding period and use of property should include the holding period of and use of the property by the transferor, in the case of property….distributed by a partnership to a partner…”
To date the IRS has not adopted this position.  If anything, over time the drop and swap appears to be increasingly disfavored by the IRS.
IRS Form 1065 U.S. Return of Partnership Income
In 2008, as part of the IRS’ attempt to limit drop and swap transactions, Schedule B 14 was added to http://www.irs.gov/pub/irs-pdf/f1065.pdf”>Form 1065. Schedule B 14 asks “At any time during the tax year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property.”  Prior to the inclusion of this check-the-box requirement, drop and swaps were frequently done on a “don’t ask, don’t tell” basis. 
As a result of this reporting requirement, it is far better, when planning on a member exchange, to distribute out to the member(s) in a tax year prior to the year in which the sale of the property takes place. This enhances the holding period requirement and separates the drop to a prior tax year from the year in which the former member is completing an exchange.  Most Section 1031 experts also strongly suggest making any of these changes prior to entering into a contract for sale.
Underlying Loan Considerations
When a deed of conveyance to a fractional interest in the real estate is given to the outgoing member, that deed is subject to whatever debt is on the property, however the debt is an obligation of the LLC and not that of the member.  As a result, the conveyance does not, by itself, act to transfer a pro-rata amount of debt to that member.  In order to avoid all the debt remaining against the LLC, the Operating Agreement or the Partnership Agreement needs to be amended to allow for a special debt allocation to flow through to the member as part of his receiving a deed to the fractional interest.
Almost all loans secured by property contain “due on transfer” clauses.  So conveying an interest in the property to one or more members may constitute a technical violation under the loan documents.  This is often overlooked since the loan payments are kept current and the property would likely be sold before a lender took notice of any transfer.
Deemed Partnership
There is a long history of case law in which the IRS has successfully argued that if a TIC holding has the attributes of a partnership, the co-ownership relationship will be deemed a partnership.  This would negate a drop and swap.  Although there are many factors that go into determining whether a co-ownership constitutes a de facto partnership, the single largest factor is the degree in which the property is managed by the TICs.  The least amount of management by the co-owners is helpful to avoid partnership characterization.  Often in an attempt to deal with this consideration, the co-owners will appoint a single co-owner as management agent for the group or will have an outside management company manage the property. 
For other various reasons, co-ownership groups will sometimes enter into a tenant in common agreement setting forth their respective rights and relationship.  The terms of such an agreement comes from IRS guidance in the form of http://www.irs.gov/pub/irs-drop/rp-02-22.pdf”>Rev. Proc. 2002-22. These agreements are often used by lawyers advising clients in order to rebut the argument of a deemed partnership.   It is generally understood in the legal community that it is almost impossible for a co-ownership structure to adhere to each and every requirement set forth in the Rev. Proc., but many people try to pattern a tenant in common arrangement to include as many of the provisions as possible.  Caution should be taken to avoid the situation where a TIC agreement is entered into, but its terms are ignored in whole or in part by the co-owners.
Summary
The possibility of structuring of a

Can a partner or member trade their share of a property interest upon sale?
One of the most common questions asked of a qualified intermediary involves the situation in which one or more members or partners in a limited liability company (LLC) or partnership wish to do a 1031 exchange and others simply wish to cash out. There are several practical difficulties in this regard starting with Section 1031 itself.  The section generally provides
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged for property of like kind which is held for productive use in trade or business or for investment”.
However the section also provides for several exclusions to the ability to trade any qualified use asset and one of those exclusions states “This subsection shall not apply to any exchange of interests in a partnership.”  As a result, the challenge here is to allow members to go their separate ways while not deeming them attempting to trade in their capacities as members. 
While there are multiple ways to structure transactions allowing various members to effectively trade their interest, by far the most common technique is for the outgoing member to have the LLC redeem the member’s interest and to convey by deed the applicable percentage interest in the property equivalent to the member’s former share.  The transfer to the member and the subsequent trade by that person is generally referred to as a “drop and swap.”
How is a 1031 drop and swap done?
A 1031 like kind exchange rules, a taxpayer’s holding period and use of property should include the holding period of and use of the property by the transferor, in the case of property….distributed by a partnership to a partner…”
To date the IRS has not adopted this position.  If anything, over time the drop and swap appears to be increasingly disfavored by the IRS.
IRS Form 1065 U.S. Return of Partnership Income
In 2008, as part of the IRS’ attempt to limit drop and swap transactions, Schedule B 14 was added to http://www.irs.gov/pub/irs-pdf/f1065.pdf”>Form 1065. Schedule B 14 asks “At any time during the tax year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property.”  Prior to the inclusion of this check-the-box requirement, drop and swaps were frequently done on a “don’t ask, don’t tell” basis. 
As a result of this reporting requirement, it is far better, when planning on a member exchange, to distribute out to the member(s) in a tax year prior to the year in which the sale of the property takes place. This enhances the holding period requirement and separates the drop to a prior tax year from the year in which the former member is completing an exchange.  Most Section 1031 experts also strongly suggest making any of these changes prior to entering into a contract for sale.
Underlying Loan Considerations
When a deed of conveyance to a fractional interest in the real estate is given to the outgoing member, that deed is subject to whatever debt is on the property, however the debt is an obligation of the LLC and not that of the member.  As a result, the conveyance does not, by itself, act to transfer a pro-rata amount of debt to that member.  In order to avoid all the debt remaining against the LLC, the Operating Agreement or the Partnership Agreement needs to be amended to allow for a special debt allocation to flow through to the member as part of his receiving a deed to the fractional interest.
Almost all loans secured by property contain “due on transfer” clauses.  So conveying an interest in the property to one or more members may constitute a technical violation under the loan documents.  This is often overlooked since the loan payments are kept current and the property would likely be sold before a lender took notice of any transfer.
Deemed Partnership
There is a long history of case law in which the IRS has successfully argued that if a TIC holding has the attributes of a partnership, the co-ownership relationship will be deemed a partnership.  This would negate a drop and swap.  Although there are many factors that go into determining whether a co-ownership constitutes a de facto partnership, the single largest factor is the degree in which the property is managed by the TICs.  The least amount of management by the co-owners is helpful to avoid partnership characterization.  Often in an attempt to deal with this consideration, the co-owners will appoint a single co-owner as management agent for the group or will have an outside management company manage the property. 
For other various reasons, co-ownership groups will sometimes enter into a tenant in common agreement setting forth their respective rights and relationship.  The terms of such an agreement comes from IRS guidance in the form of http://www.irs.gov/pub/irs-drop/rp-02-22.pdf”>Rev. Proc. 2002-22. These agreements are often used by lawyers advising clients in order to rebut the argument of a deemed partnership.   It is generally understood in the legal community that it is almost impossible for a co-ownership structure to adhere to each and every requirement set forth in the Rev. Proc., but many people try to pattern a tenant in common arrangement to include as many of the provisions as possible.  Caution should be taken to avoid the situation where a TIC agreement is entered into, but its terms are ignored in whole or in part by the co-owners.
Summary
The possibility of structuring of a

Can a partner or member trade their share of a property interest upon sale?
One of the most common questions asked of a qualified intermediary involves the situation in which one or more members or partners in a limited liability company (LLC) or partnership wish to do a 1031 exchange and others simply wish to cash out. There are several practical difficulties in this regard starting with Section 1031 itself.  The section generally provides
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged for property of like kind which is held for productive use in trade or business or for investment”.
However the section also provides for several exclusions to the ability to trade any qualified use asset and one of those exclusions states “This subsection shall not apply to any exchange of interests in a partnership.”  As a result, the challenge here is to allow members to go their separate ways while not deeming them attempting to trade in their capacities as members. 
While there are multiple ways to structure transactions allowing various members to effectively trade their interest, by far the most common technique is for the outgoing member to have the LLC redeem the member’s interest and to convey by deed the applicable percentage interest in the property equivalent to the member’s former share.  The transfer to the member and the subsequent trade by that person is generally referred to as a “drop and swap.”
How is a 1031 drop and swap done?
A 1031 like kind exchange rules, a taxpayer’s holding period and use of property should include the holding period of and use of the property by the transferor, in the case of property….distributed by a partnership to a partner…”
To date the IRS has not adopted this position.  If anything, over time the drop and swap appears to be increasingly disfavored by the IRS.
IRS Form 1065 U.S. Return of Partnership Income
In 2008, as part of the IRS’ attempt to limit drop and swap transactions, Schedule B 14 was added to http://www.irs.gov/pub/irs-pdf/f1065.pdf”>Form 1065. Schedule B 14 asks “At any time during the tax year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property.”  Prior to the inclusion of this check-the-box requirement, drop and swaps were frequently done on a “don’t ask, don’t tell” basis. 
As a result of this reporting requirement, it is far better, when planning on a member exchange, to distribute out to the member(s) in a tax year prior to the year in which the sale of the property takes place. This enhances the holding period requirement and separates the drop to a prior tax year from the year in which the former member is completing an exchange.  Most Section 1031 experts also strongly suggest making any of these changes prior to entering into a contract for sale.
Underlying Loan Considerations
When a deed of conveyance to a fractional interest in the real estate is given to the outgoing member, that deed is subject to whatever debt is on the property, however the debt is an obligation of the LLC and not that of the member.  As a result, the conveyance does not, by itself, act to transfer a pro-rata amount of debt to that member.  In order to avoid all the debt remaining against the LLC, the Operating Agreement or the Partnership Agreement needs to be amended to allow for a special debt allocation to flow through to the member as part of his receiving a deed to the fractional interest.
Almost all loans secured by property contain “due on transfer” clauses.  So conveying an interest in the property to one or more members may constitute a technical violation under the loan documents.  This is often overlooked since the loan payments are kept current and the property would likely be sold before a lender took notice of any transfer.
Deemed Partnership
There is a long history of case law in which the IRS has successfully argued that if a TIC holding has the attributes of a partnership, the co-ownership relationship will be deemed a partnership.  This would negate a drop and swap.  Although there are many factors that go into determining whether a co-ownership constitutes a de facto partnership, the single largest factor is the degree in which the property is managed by the TICs.  The least amount of management by the co-owners is helpful to avoid partnership characterization.  Often in an attempt to deal with this consideration, the co-owners will appoint a single co-owner as management agent for the group or will have an outside management company manage the property. 
For other various reasons, co-ownership groups will sometimes enter into a tenant in common agreement setting forth their respective rights and relationship.  The terms of such an agreement comes from IRS guidance in the form of http://www.irs.gov/pub/irs-drop/rp-02-22.pdf”>Rev. Proc. 2002-22. These agreements are often used by lawyers advising clients in order to rebut the argument of a deemed partnership.   It is generally understood in the legal community that it is almost impossible for a co-ownership structure to adhere to each and every requirement set forth in the Rev. Proc., but many people try to pattern a tenant in common arrangement to include as many of the provisions as possible.  Caution should be taken to avoid the situation where a TIC agreement is entered into, but its terms are ignored in whole or in part by the co-owners.
Summary
The possibility of structuring of a