1031 Puzzler Of The Week- Very Long
Two different exchange accommodators, as well as a CPA, were given the following scenarios and and asked about their legality. The two accommodators disagreed; the CPA agreed with one of them, but with a different justification.
If anyone has any thoughts on this issue, I'd appreciate hearing them:
Party "A" and Party "B" are tenants in common on two properties, with 50% ownership in each. The equity in each property is the same.
They wish to dissolve their partnership and also defer any tax liability.
Their first plan was to exchange their interests in each property. "A" would exchange his 50% of Property 1 for the 50% of Property 2 owned by "B". So "A" would become the sole owner of Property 2, and "B" the sole owner of Property 1.
They were first told this was a valid exchange, then told it was not.
Next they proposed selling both Property 1 and Property 2, and taking the proceeds and exchanging them for two other properties of equal value. "A" would take sole ownership of one of the new properties, and "B" would take the other.
Again, there were dissenting opinions as to the validity of this exchange.
Do either of these exchanges qualify under 1031 guidelines? If not, are there any other ways to dissolve this partnership and defer the tax consequences?
Thanks very much for any feedback.
Tracy
The first question is are they really tenants in common or are they in a partnership?
The two scenarios are possible, but would depend on the answer to my first question.
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Hi Bill,
Thanks for the reply. The parties have a tenants in common agreement, but they are not listed as tenants in common on the grant deeds. On the grant deeds they are listed as Mr. A and Mr. B, with each holding an undivided 1/2 interest in the property.
However, one accommodator said that they are considered a partnership by default, even if they do not file a partnership tax return. Thus they would not qualify for a 1031, as the IRS allows an exchange of partnership ASSETS, not partnership INTERESTS.
Tracy
So how did you report these buildings income & expense on your taxes? As a partnership? Did you file a K-1 or what?
I suspect that since you are each in effect taking the others interest as an in-kind settlement this is not a taxable event. But from a tax point of view basis and depreciation may be more important than equity. Are the two properties about equal on that basis as well?
Hi commercialking,
The income and expenses were reported on Schedule E for both parties as they are rental properties. No 1065, no K-1.
Depreciation and basis are pretty close on the properties. Both parties are willing to compensate the other to cover the difference. But I guess their main concern is if their co-ownership automatically makes them a partnership, which would restrict their use of a 1031 exchange.
Thanks very much,
Tracy
First of all, the accommodator that said they are considered a partnership by default is completely and absolutely wrong. You are only considered a partnership automatically if you treat it like a partnership, report it like a partnership and/or have a formal partnership agreement.
You are not automatically considered to be a partnership just because you hold title as Mr. A and Mr. B as to an undivided 50% interest. You may be considered to be a partnership if you act like one. A tax attorney would have to look at the activities of the two and compare it to the IRS guidelines to determine if they are acting and treating it as a partnership, which I would doubt based on what you have told us. The fact that they also have a formal TIC agreement is even better.
The first plan that you posted where by Mr. A. and Mr. B simply swap ownerhship interests so that Mr. A ends up owning 100% of one property and Mr. B ends up owning 100% of the other property is a true and pure 1031 exchange just like it used to be done in the "old days". If there is any discrepancy in values, then one party pays the difference in cash to the other party and would create a small amount of taxable boot. There is no magic here. It is a very simple 1031 exchange. After that, each party can do what ever they want and go their separate ways. However, once the swap has been made, be sure that each party holds 100% of their respective property for a period of time to demonstrate they had the intent to hold 100% of the property for investment. See article: http://comm.thecreativeinvestor.com/modules.php?name=News&file=article&articleid=572&mode=thread&order=1&thold=-1.
And, finally, because this is a two party swap, you do not need an accommodator unless there will be any cash boot paid to one of the parties and they want to use that to acquire a second property.
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Bill Exeter[ Edited by wexeter on Date 08/11/2004 ]
Hi Bill,
Thanks very much for the detailed reply. You've really helped me clarify this situation, although I'm still not exactly sure how "acting like a partnership" is defined. The two parties are both engaged in the management of the property, share rents and expenses, etc. From reading the IRS code, it sort of seems like being a partnership is something you elect to do, not something you're required to do. But I could be wrong about this, and I'll consult a tax attorney as you suggested.
I appreciate the link, also.
Thanks,
Tracy
You can certainly elect to be a partnership, draft and execute a formal partnership agreement, file form 1065, etc. This way you are a partnership.
However, you may not want to be a partnership. You may have taken title as tenants-in-common. You split the rents, expenses, capital gains, etc. and report it as individuals on your income tax returns. The IRS has certain guidelines that "define" a partnership by the actions of its partners so that even if you do not want to be a partnership you may be considered to be a partnership by the IRS. This is outside of my area of expertise, so I can only point out the general issues. Your tax attorney can go through the check list with you to make sure that you are not "deemed" to be a partnership.
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Bill,
Just spent a couple of hours on the phone with the IRS. Talked with two different people on their "specialty business tax line." The first person was about 99% sure that rental property held as a tenancy in common was NOT considered a partnership, unless you wanted it to be. The second person, of course, felt quite strongly that it was a partnership.
These people are the third "tier" of representatives at the IRS, so they are supposed to be the most experienced and knowledgeable. After researching the issue, they both said that they couldn't find anything in the code that specifically addressed this question. They checked Rev. Proc. 1.761-A and the section on partnerships. They said the code defines partnerships, and states the reporting requirements, but doesn't get into whether or not a TIC between 2 people who own rental property MUST file as a partnership.
Quite frankly, I was surprised that the people I spoke with were so willing to spend so much time trying to help. They were amazingly friendly, and were amused that the IRS itself couldn't tell me how to file and that I may need to talk with a tax attorney. One compared it to registering a car at the DMV and being told that they weren't sure how this particular car would be registered, so I better get a lawyer. Too funny.
Anyway, thank you, Bill, for all your help as well- it's much appreciated.
Tracy
You are most welcome. This is the problem with many areas of the tax code. Our knowledge and opinions have been developed over many years of consulting with attorneys and experience. Glad we could be of assistance.
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