201401.05
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Like-Kind Exchanges Involving Partnership Property

If you own rental real estate, you probably think you can exchange it for “like-kind” real estate some day, and defer any gain that would otherwise be recognized in that transaction. You would probably be right.
And if you own rental real estate together with others, you probably believe that you could similarly exchange your interest in the underlying real estate for “like-kind” property and similarly defer recognition of any gain on that transaction. You would probably be wrong if you and your other co-owners are partners, and the underlying real estate is owned by the partnership.

Sometimes partners want to separate and apply their share of disposition proceeds independently, with some or all of them wishing to acquire replacement property through separate like-kind exchanges. They face the problem of not directly owning an asset to exchange. Instead, each owns a partnership interest and partnership interests are explicitly excluded from like-kind exchange treatment. The key problem is how to be treated as owning a direct interest in the underlying real estate that qualifies for like-kind exchange treatment.

Three techniques have been used in the past to accomplish this:

1. Drop and Swap.

This involves terminating the partnership and distributing its property to the partners, who acquire direct ownership as tenants-in-common. The partners complete the sale or exchange of their fractional interests.

2. Swap and Drop.

This involves the partnership completing the exchange and distributing replacement property to its partners.

3. Separation without Divorce.

This involves the partnership completing the exchange and using post-exchange transactions to direct the economic benefits to particular partners. The partnership remains in existence.

Each of the above techniques has a number of tax problems and other disadvantages. A recent Treasury Department Revenue Procedure (Rev. Proc. 2002-22) adds to these problems. In particular, property distributed by a partnership to its partners and held directly as co-owners will probably no longer qualify for tax-free exchanges. This may eliminate the first two of the above techniques.

New acquisitions can be structured to avoid these problems. This will require acquiring the property as tenants-in-common, rather than as partners. (Acquiring the property in a limited liability company will not work. Limited liabilitycompanies are considered partnerships for Federal income tax purposes.) A tenants-in-common agreement can provide many of the protections of a partnership agreement, though care must be taken to comply with the requirements of the new Revenue Procedure. In fact, there are certain non-tax advantages of acquiring property as tenants-in-common. For example, the other co-owners are not agents for one another, as partners are, reducing exposure to liability for the acts of others.