PARTNERSHIP EXCHANGES:  ADMITTING NEW PARTNERS TO SATISFY THE DEBT REPLACEMENT REQUIREMENT

By Michael Wiener, Tax Partner, Greenberg Glusker

Real estate is often owned by partnerships (or LLCs that are taxed as partnerships).  Therefore, partnerships are often involved in 1031 exchanges.  Partnership 1031 exchanges involve issues that do not exist in exchanges conducted by other types of taxpayers, such as individuals, trusts, or corporations.

One issue that often arises in partnership exchanges is admitting new partners in the middle of the exchange (after the relinquished property has been sold but before the replacement property is acquired). A partnership might admit a new partner to raise non-exchange proceeds so that it can satisfy its debt replacement requirement.

From a strictly 1031 exchange perspective, this works.  The partnership is the “taxpayer” in the exchange, and this does not change, even if the roster of partners changes.  Further, a partnership, like any other taxpayer, can satisfy its debt replacement requirement by using non-exchange proceeds, including non-exchange proceeds contributed by new partners.  However, 1031 exchanges do not exist in a vacuum, and the rules under Subchapter K of the Internal Revenue Code (which governs partnership tax) can trigger negative tax consequences for the legacy partners, even though the partnership avoids boot in its exchange.

Using non-exchange proceeds to satisfy a partnership’s debt replacement requirement will reduce the amount of debt on the partnership’s balance sheet. Under the Subchapter K rules, the legacy partners will be treated as having received a distribution of cash (even though they don’t actually receive any cash).  In certain circumstances, this “deemed distribution” can result in taxable income to a legacy partner, either immediately or as a result of a future distribution that would not otherwise be taxable.

In sum, partnerships have considerable flexibility in reshaping their ownership in connection with 1031 exchanges. However, doing so requires careful planning to avoid unintended tax consequences.

To connect with the Genesis Bank Exchange team call 800.797.1031 or explore further details on our website: https://www.mygenesisbank.com/1031Exchange.