Even when the sole asset of a partnership or LLC is real estate, the interest in the entity is considered to be a form of intangible personal property in the hands of the partner or member. Accordingly, an exchange of an interest in an entity-holding property for real estate is not considered the exchange of like-kind assets. In addition, the holding period (for purposes of calculating the timeframe discussed in question 3) for any property distributed from an entity to its owners will begin upon receipt of the property.
When a partnership wishes to dispose of real estate, there may be a difference of opinion between partners who wish to reinvest under section 1031 and those who wish to cash out. One solution is to have those partners who desire to remain in the partnership make a liquidating distribution to the others. Provided there is no technical termination of the partnership, the partners cashing out can receive consideration for their partial interests, while the remaining partners take advantage of section 1031, with the partnership as the exchanging taxpayer.
Revenue Procedure 2002-32 has recently provided insight in the area of partial real estate interests or undivided fractional interests (UFI), which are being considered either as the replacement property or as the property to be relinquished in an exchange. Revenue Procedure 2002-32 addresses the prerequisites for submitting a Private Letter Ruling request to the IRS regarding a non-partnership tenant in common (TIC) arrangement by noting:
There must be pro-rata sharing (in proportion to the TIC co-owner’s percentage interest in the underlying title) of profits, expenses, cash distributions, and indebtedness.
Up to 35 TIC co-owners are permitted to own a single parcel (or multiple parcels that are contiguous or related in use).
Customary investment real estate activity may be undertaken by the TIC co-owners (e.g., repair and maintenance); business involvement may not.
The use of a common bank account for the benefit of the TIC co-owners is acceptable as long as separate reporting is provided to the co-owners.
An annually renewable contact with a leasing management company, and arrangements such as voting agreements, call options, and rights of first offer or refusal among the TIC co-owners, are permissible with certain restrictions.
As a result of the limitations contained within Revenue Procedure 2002-32, advisers may want to consider a master lease for multi-tenant property that provides for a sublessor (such as the sponsor packaging the TIC interests) to pay a net lease amount to the co-owners.
Several recent private letter rulings have permitted taxpayers disposing of individually-owned real estate to receive the membership interest in a single-member LLC that owns the replacement real property. This arrangement may be beneficial to taxpayers concerned about liability exposure. The use of LLCs as the preferred entity for real estate holdings is discussed in two of the author’s previous articles, “Twenty Questions on Selection of a Legal Entity” (The CPA Journal, August 1999) and “Twenty Questions on Protecting Business and Family Assets” (The CPA Journal, February 2000).
Though the subject article emphasizes deferred section 1031 exchanges undertaken by individual taxpayers, all of the various types of business organizations, including trusts, are able to utilize section 1031 by disposing of entity-owned real estate and later acquiring replacement real property.