Administrative challenges in 1031 exchanges with multiple cashing out partners

10/28/2016 | Articles & Alerts

A tricky issue arises in 1031 exchanges when some partners want to cash out on the sale of the relinquished property rather than stay invested in a replacement property. The issue may be exacerbated when many partners, all with varied interests, want to be cashed out. Determining the easiest way to cash out partners is challenging because the partners may be cashed out in several ways.

One option is for the partnership to complete the 1031 exchange, refinance the replacement property and then cash out partners with the proceeds. This is problematic because it does not immediately address the partners’ desire for cash. Another technique is for the partnership to liquidate and distribute the property to its partners, as tenants-in-common, who then sell the property and use the proceeds to complete the 1031 exchange or cash out. Similarly, if the partnership wanted to continue as an investor in the replacement property, it may distribute tenancy-in-common interests to a portion of the property to the leaving partners, and the parties proceed with the 1031 exchange or cash out.

Assume that the partnership is ongoing and so, distributes a portion of the property to leaving partners as tenants-in-common. Aside from tax code compliance issues, the parties will have more straightforward administrative issues in the property’s distribution and eventual sale.

When the property is distributed to the partners as tenants-in-common, problems arise with title and co-ownership. Title must properly reflect all the various tenants-in-common, with their corresponding ownership percentages. A co-tenancy agreement may be negotiated but will have to incorporate the various parties’ rights, duties and obligations. With respect to the sale of the property, problems abound in the negotiation of the sale agreement and post-sale obligations. The buyer of the relinquished property will want to negotiate only one purchase agreement, with ongoing obligations as to the seller, such as holdbacks or indemnification and reimbursement obligations. To incorporate the various sellers into a single agreement may be burdensome or delay the sale. Post-sale, all sellers must report the sale on each of their tax returns.

Forming an LLC to represent the leaving partners is one solution to these administrative issues. The leaving partners contribute their partnership interests to the LLC in exchange for LLC membership interests. The partnership distributes a portion of the property to the LLC as a tenant-in-common. The parties complete the sale of the relinquished property. The LLC receives cash from the sale and then makes distributions to its members in respect of their LLC membership interests. Meanwhile, the partnership has continuity of title and may go on to complete the 1031 exchange.

The LLC helps to simplify issues because fewer parties are involved in the ownership and sale of the property. Titling of the property becomes easier. Within the LLC operating agreement, members negotiate their various rights, duties and obligations with respect to each other and designate a member to represent the LLC in transactions with respect to the property. The LLC negotiates the terms of a co-tenancy agreement with the partnership, the terms of the sale agreement, and files required tax returns.

Ultimately, any time partners desire to be cashed out on the sale of a relinquished property, a 1031 exchange becomes more complex because of varied interests. Addressing the complexities requires careful tax considerations and creative administrative solutions.