Partnership Restructuring to Add Flexibility and Minimize Tax Impact

Disputes between partners in a partnership is a common occurrence and should be an expected hurdle for partners from the beginning of a business venture. The impact of partnership taxation and lack of flexibility of like-kind exchanges is often the cause of some of these disputes. It is not unheard of for one partner of a partnership to have a long term view to exchange partnership property in a like-kind exchange, while the other partner(s) do not have this goal but instead desire to cash out their investment sometime in the future. If the property is in the partnership and the other partner doesn’t consent to the like-kind exchange, what can be done?

Assume that two individual partners own an apartment building together and one of them is interested in using in the long run the partnership property in a like-kind exchange but the other does not have this goal. How can the partners resolve their differences while avoiding partnership taxation events? A viable solution is to actually dissolve the partnership and liquidate the assets. This doesn’t mean the project is kaput.  The solution lies in transferring the property to the former partners as tenants in common, but rather than transferring it directly to the partners, the tenancy in common real estate is instead transferred to the former partners’ single-member LLCs. A Tenants in Common Agreement is executed between the two LLCs to operate the project. An independent real estate management company is hired to manage the apartment project for the two tenants in common, i.e., the former partners who hold their interests through their respective single member LLCs which are disregarded for tax purposes. Thus their share of the rental income and expenses would be included in their respective individual tax returns for the year and a partnership return is not filed.

Later if the two tenants in common should decide to sell the apartment building, the current arrangement is flexible enough so that the partner who desires to cash out his investment can do so while the other tenant in common can pursue a like-kind exchange for his 50% undivided interest in the apartment building. This can be accomplished by selling the apartment building to a third party for cash. The tenant in common who does not wish to utilize like-kind exchange can receive his share of the proceeds in cash, the other tenant’s share of the cash proceeds remains in the escrow with a qualified intermediary while replacement like-kind property is identified under Section 1031(a)(3) of the Code. The tenant in common has 45 days to identify like-kind property to be used as the property to be received in the exchange and up to 180 days to receive the identified property. This type of 1031 exchange is commonly referred to as a Starker 1031 exchange named after the case which first allowed such a deferred exchange and which gave birth to the statutory provisions of Section 1031(a)(3) of the Code.

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*This post was originally published on July 12, 2016