Exchanges Involving Pass-through Entities
There is some controversy over what is considered property held for investment when immediately subsequent to the exchange, the property is transferred to a pass-through entity. In Magneson, the 9th Circuit held that property that was acquired in a like-kind exchange as an investment but immediately contributed to a California general partnership (which held only the one property) did not lose its status as investment property. The Court held that the transfer of the property was a continuation of the investment, unliquidated, but modified in form. They based their opinion largely on the fact that, after the transfer, the Magnesons still owned and managed (as general partners) the same portion of the property.
Accordingly, it is questionable whether a transfer by an individual to a limited partnership, LLC, or S corporation would be exempt under the facts of this case, since the rights of the owners would be different. It is also doubtful that the Court would reach the same decision if the Magnesons had contributed the property to an entity that held additional properties, thereby diversifying their holdings.
Some taxpayers have also used the Magneson decision to justify distributing partnership property to partners to allow some partners to take advantage of the like-kind exchange rules to dispose of their interest in a partnership asset when other partners wanted to sell their interests in the property. It is not certain how such transactions will be taxed. Obviously, the more time between the distribution of the property and the sale of the property, the more likely it is that the IRS will concede that the property was held for use in a trade or business or for investment by the owners. It is best if the property is distributed before the sales contract is signed to provide a strong argument that the partners receiving the property have a substantial risk that the sale is not certain. Another problem that may arise with such a transaction is that the partners holding the distributed property as tenants in common may be deemed to enter into a new partnership. If so, IRC Sec. 1031 will not apply since the new partnership will be treated as the seller. This may be sidestepped by entering into a net lease with a lessee and then electing out of partnership tax treatment. Without the net lease, the IRS still has the ability to argue that the tenants in common are engaged in a trade or business, denying them the ability to elect out of partnership tax treatment.
Although partnership interests do not qualify as like-kind property under the rules of IRC Sec. 1031, partnerships can make like-kind exchanges of their qualifying assets. Practitioners should note that in TAM 9818003, the partners in a partnership tried to circumvent the rules disallowing the like-kind exchange of partnership interests by entering into a deferred like-kind exchange of the partnership’s only asset, with the qualifying properties being distributed to the partners in liquidation of their interests, rather than to the partnership. In this situation, the IRS held that the partnership did not enter into an exchange qualifying for nonrecognition treatment. The IRS has privately ruled that when a limited partnership relinquished property in a like-kind exchange and created a disregarded wholly owned LLC to receive all of the ownership interests in a partnership owning the replacement property, a gain deferral under IRC Sec. 1031 was allowed (Ltr. Rul. 200807005).
Note that IRS rulings and court cases have addressed whether the qualified use of property (a requirement for a successful Section 1031 exchange) can be attributed from a partnership to a partner or vice versa. Since there is currently no clear answer concerning this issue, be careful when structuring Section 1031 exchanges where property is contributed to a partnership in anticipation of exchanging that property in a like-kind exchange. The property received in the exchange is contributed to a partnership by a partner subsequent to that partner’s receipt of the property in a like-kind exchange, the property to be exchanged is distributed to the partners in anticipation of the exchange, or the property received by a partnership in a like-kind exchange is distributed to the partners immediately after the exchange. In such cases, at a minimum, practitioners should consider having the client transfer the property before entering into a binding agreement to exchange the property. The longer the property is held between the date of transfer and the date of exchange the better. The IRS, in Ltr. Rul. 8429039 provided that a two-year holding period is sufficient to ensure treatment as a tax-free exchange (all other tests being met). It appears that any holding period shorter than 24 months, while not disqualifying the transaction from Section 1031 treatment, will make the transaction suspect in the eyes of the IRS.
When determining whether a like-kind exchange is feasible, differentiate between a partnership interest and an undivided fractional share (which can be exchanged by a co-owner under the Section 1031 rules—see Rev. Proc. 2002-22). This should not be difficult in the case of an interest in an LLC taxed as a partnership, since the formation of an LLC requires filing written documents with the state of formation (as opposed to a partnership, which may be formed based on an oral agreement).