John F. Soukup
Division of ownership of properties held in partnership
January 2021

Facts: Taxpayer 1 and Taxpayer 2 own a limited liability company on a 50/50 basis. The LLC holds commercial real property and which is encumbered with a loan from a commercial lender. Taxpayer 1 and Taxpayer 2 would like to exchange out of the jointly owned property into replacement properties which each would own independently of the other. The LLC is taxed as a partnership.

Question: Can Taxpayer 1 and Taxpayer 2 separately exchange the properties held by the LLCs?

Answer: Yes, but each of the methods available to accomplish this goal has is shortcomings.

Reasons:

The following analysis refers to partners and partnerships but applies equally to members of limited liability companies taxed as partnerships.

Drop and Swap. This is the method most commonly used to allow partners to exchange real property. It consists of transferring the real property from the entity owning the property to the members as tenants in common who then exchange the real property. According to the literature, the safest way to do this is to terminate the entity, transfer the property to the partners as tenants in common, file a final tax return for the entity and make a Section 761(a) election not to be taxed as a partnership. Thereafter the tenants in common should own the property for some period of time and only then the tenants in common enter into listing agreements, purchase agreements and similar documents. Operating expenses should be paid by the individual tenants in common. Income should be paid too. Conservative counsel is to hold the property as tenants in common for at least two tax years before exchanging the property.

Drop and Swap is undergoing increasing scrutiny by the IRS and the California Franchise Tax Board. The IRS partnership tax return form was amended in 2008 to add specific questions about distribution of property from the entity. These questions identify potential Drop and Swap transactions for IRS review.

The avenues for challenge of a Drop and Swap by the government include:

1. The step transaction or substance over form theory;
2. Whether the co-tenancy is a partnership for tax purposes;
3. Whether the taxpayer has held the property for investment or for use in a trade or business.

A substantial holding period, such as 2 years, should avoid problems with challenges 1 and 3, and would also allow the taxpayer to avoid reporting an exchange on their tax return in the same year that a distribution of property is reported on the return.

Challenge 2 arises from the fact that the IRS holds that co-owners are partners for tax purposes if there is a significant level of management by the owners regardless of the form of ownership the owners claim to be using. IRS regulations state that the mere co-ownership and rental of property which is maintained and kept in repair by the owners does not constitute a partnership. A partnership does exist if co-owners lease space and, in addition, provide services to the occupants either directly or through an agent. This is a murky standard and it is hard to advise what can and can not be done if co-owners want to avoid partnership tax treatment.

Although California generally follows federal tax law, the Franchise Tax Board takes an independent, and perhaps tougher view. It says the essential question is whether the parties intended to, and did in fact join together for, an undertaking or enterprise. Some of the factors that the FTB will consider in determining the type of property interest involved, with no single factor being determinative include: the agreement of the parties, and their conduct in executing its terms; the contributions that each party makes to the venture; control over income and capital, and the right of each party to make withdrawals; whether the parties are co-proprietors who share in net profits and have an obligation to share losses; whether business was conducted in the joint names of the parties; whether the parties held themselves out as joint ventures; and whether separate books of account were maintained for the venture.

One solution to the management issue is to hire an independent third party property manager or master lease the property to an independent party.

In addition to the tax requirements, lender approval will be required, including approval of the proposed independent property manager or master lessee.

Several other solutions are available:

Partnership acquisition of multiple properties and later distribution in liquidation.The partners can each designate a separate replacement property and the partnership can acquire the designated replacement properties. The partnership then must continue to operate as a partnership owning the replacement properties following the exchange for an indefinite period. In addition the members must continue to share the economic performance as well as appreciation and depreciation of all the properties. Income and expense should not be specifically allocated to one or the other partner, all need to share in all of the properties.

The partnership can dissolve and distribute the replacement properties out to the respective members at some point in the future when the exchange is old and cold. Two years would most likely be considered long enough.

Problems with this approach can include, if the partnership identifies under the three property rule, each partner can designate one alternative, but who gets the third alternative? If the 200% rule is used 200% of value will have to be allocated between the members and they will have to be careful that they do not exceed their allocated value or the whole identification will be invalid. If the partnership identifies more than 3 properties and more than 200% of the value of the relinquished property, then the exchange can only be saved by acquiring 95% of the identified properties. Which may be difficult to do. Further, if one of the replacement properties is not acquired, the partnership has a 50% trade down in value and the partnership will recognize significant gain on the exchange, possibly negating any gain deferral. Any such gain under the partnership accounting rules is allocated between the members according to their ownership interests, not to any one partner, meaning that both partners will recognize gain because of a partially failed exchange.

Partnership Division. Under this method the LLC holding the property divides into two separate LLCs, each owned by at least two of the members. A resulting partnership resulting from such a division is considered to be a continuation of the dividing partnership if the resulting partnership has members who owned more than 50% in the capital and profits of the prior partnership. Under this method there will be some overlapping of ownership. For example, the LLCs could divide into two LLCs; one owned 99% by Taxpayer 1 and 1% by Taxpayer 2 and the other owed 99% by Taxpayer 2and 1% by Taxpayer 1. The 1% interests could be bought out at some time in the future, probably after 2 tax years have passed. If the resulting LLC does not meet the continuation rules, then it is treated as a new partnership and the exchange would be subject to the tax risks set forth under the Drop and Swap discussion above.

No matter which method is chosen there is an element of risk. There are not many cases to give guidance and the IRS sometimes takes a different position than the Courts, meaning that if the transaction is audited, and an unfavorable ruling is made, the matter may need to be litigated in court to arrive at the treatment dictated by the case law.

“This information is for educational purposes only and not intended to constitute legal advice. Every project and property is unique. Please seek legal counsel for advice specific to your project.”