In a previous article, we provided an in-depth view of like-kind exchanges. But what particularly does this mean for partnerships?
If structured properly, a 1031 exchange (often called a like-kind exchange) can be an excellent strategy to defer taxes when a property is sold. In general, a 1031 exchange involves a sale of real property and the identification and reacquisition of “like-kind” property through a qualified intermediary within certain timeframes specified by the law.
However, challenges exist when additional partners are added into the mix. If property is owned in an LLC taxed as a partnership (or a corporate entity such as an S or C corporation), the transaction is done at the entity level and not the partner level. This can create problems as partners may have different investment horizons and objectives.
For instance, when a property is sold, some partners may wish to reinvest their proceeds while others may wish to cash out. Due to the mechanics of a like-kind exchange, when boot (cash and debt relief) is received, it can create undesirable consequences. Here is an example:
- Bob and Bill each own 50% of B&B Land Holdings, LLC (which is taxed as a partnership), which owns a piece of land held for investment. The land originally cost $200,000 and is currently under contract to be sold for $500,000 (after closing costs). Additionally, there is no debt on the property.
- The realized gain on the sale of the property will be $300,000 (the $500,000 of proceeds minus the $200,000 of original cost).
- Bob wishes to use a 1031 exchange for his half of the proceeds and defer the gain while Bill would like a distribution of $250,000 cash.
- Options for the sale are as follows:
- Sell the land, forego a like-kind exchange and distribute the cash proceeds to Bob and Bill.
- Sell the land, undergo a like-kind exchange for all sale proceeds and acquire a new piece of investment property to be owned by B&B Land Holdings, LLC (with Bob and Bill continuing to be a 50% owner).
- Sell the land, undergo a like-kind exchange for half of the proceeds and distribute the other half of the proceeds to Bill in exchange for his partnership interest.
- On the surface, Bob and Bill prefer option 3 because it accomplishes their objectives. They decide to run the transaction by their tax advisor—who advises them of the tax consequences for each option:
- For an outright sale, Bob and Bill would receive a distribution of $250,000 (half of the proceeds) and have a taxable gain of $150,000 (half of the realized gain). Assuming the highest long-term capital gains rate (20%) and the net investment income tax (3.8%), the tax would be approximately $36,000 each.
- For a full like-kind exchange, Bob and Bill would not receive any cash distributions, but would also not have any taxable gains. The newly acquired property or properties would have a tax basis of $200,000 (plus any additional funds invested) and still be owned by B&B Land Holdings, LLC.
- For a partial like-kind exchange, B&B Land Holdings, LLC would be deemed to have boot (i.e. proceeds received) of $250,000. The recognized gain is the lesser of realized gain ($300,000) or boot received ($250,000) which is equal to $250,000. Bill would receive his distribution of $250,000 and likely a gain (after special allocations) of $150,000 to balance his capital out to zero. Bob, on the other hand, would also receive the remaining gain of $100,000 (with a tax liability of approximately $24,000), no cash and the newly acquired property with a basis of $200,000.
- For obvious reasons, Bob did not like this answer as he incurred a tax liability with no cash proceeds to pay the liability and was only able to defer a third of his gain in the property.
- Given these consequences, either Bob or Bill is forced to compromise to go with option 1 or 2 or decide to stop the sale entirely and continue to hold the land.
When partners have differing objectives, it is important to consult your tax advisor as early as possible (even before the initial acquisition) to spell out your investment goals. He or she can advise you of the best structure for both the acquisition and the sale so you can achieve your goals in a tax efficient manner.
For Bob and Bill, this could have meant acquiring the land originally as tenants-in-common instead of through an LLC, structuring a buy-out, or employing a more complicated strategy to divide the partnership. If the property is already under contract or will sell very soon, it is often too late.
The real estate CPAs at James Moore have the specialized knowledge not only about real estate tax concerns, but about how they affect your partnership as well. Contact us today to get the most out of your transaction.
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