Investment real estate is frequently owned by a partnership of investors who hold title in the partnership's name. Likewise, property owned by tenants in common acting as business or investment partners may be deemed partnership property for tax purposes, regardless of whether or not a formal partnership agreement exists. (See Treas. Reg. §1.761-1(a).) A partnership, as a taxpaying entity, may clearly benefit from capital gains tax deferment by exchanging its qualifying real property assets for like-kind property in a 1031 exchange. Less favorable tax treatment may result, however, when an individual partner seeks to exchange his interest in the partnership's real estate assets for like-kind real estate he wants to acquire in his name individually. IRC § 1031(a)(2)(D), enacted as a part of the Tax Reform Act of 1984, excludes a partnership interest as eligible exchange property. In some instances, with careful pre-exchange planning, partners may be able to restructure their ownership of exchange property in a manner to overcome this obstacle.

Section 761(a) Election

Thanks to statutory provisions found in IRC § 1031(a)(2) and Treas. Reg. § 1.1031(a)-1, which were enacted as part of the Omnibus Budget Reconciliation Act of 1990, the taxpayer's objective of individual tenancy-in-common ownership can best be accomplished if the partnership has made a valid § 761(a) election, excluding it from the application of subchapter K. The individual partners will then be considered owners of the underlying assets in the partnership rather than owning partnership interests, enabling each partner to exchange his interest in the real property for like-kind property. In order to make a valid § 761(a) election, the partnership must be used for investment purposes only and not for the active conduct of a business. The income of the partners must also be able to be determined without the necessity of filing a partnership return. The Internal Revenue Service, in Tech. Adv. Mem. 9214011 (December 26, 1991), treated a partner's sale of its interest in partnership property to the other partner as the sale of the partner's interest in the underlying real property rather than a sale of a partnership interest because the partnership had made a valid § 761(a) election.

Jeremiah Long and Mary Vrbanac, in section 9:09 of their treatise, Tax-Free Exchanges Under § 1031 (West Group, 1998), discuss key issues in determining whether a partnership exists for tax purposes, and in section 7:24, they provide a sample 761(a) Election form. They caution that if partnership tax returns have been filed in the past, a final partnership return should be filed with a 761(a) election before entering into a contract for the sale of relinquished property in an exchange. Accordingly, each partner's proportional share of income and expenses related to the property should be reported on his individual tax return. Long and Vrbanac also recommend terminating any partnership agreement which has terms allowing one partner to control the interest of another, replacing the partnership agreement with a co-tenancy agreement. The partnership would then make a § 731 tax-free distribution of the property to the partners as tenants in common.

A § 761(a) election and a § 731 distribution should be made well in advance of the exchange to avoid attack by the IRS under step-transaction theory, where the IRS may ignore certain steps of a transaction if they are deemed undertaken solely to avoid taxation. Allowing some time between the distribution to the partner and the partner's exchange will also enable the exchangor to individually meet the qualified use test of owning "property held for productive use in a trade or business or for investment." The "held for" provision of § 1031 has frequently been used by the IRS to deny exchange eligibility to taxpayers who acquire the relinquished property shortly before its transfer, or who sell or distribute the replacement property shortly after its acquisition. Unfortunately, no specific holding period has been designated in the tax code, so special care should be taken to ensure this requirement can be satisfied by the taxpayer.

Other variations of exchanges with similar partnership exchange issues should also be considered. For example, if a taxpayer wishes to convey his fee simple interest in real property in exchange for a partial interest in replacement property to be acquired with some partners, has the taxpayer acquired a co-tenancy interest rather than a partnership interest in the replacement property? If a partnership wishes to effect an exchange, and shortly thereafter distribute the replacement properties to the partners, has the qualified use test been met by the partnership as to the replacement properties? Because taxpayers have met with varying success, and in order to avoid the pitfalls that have caused some such exchanges to fail, an attorney should carefully study and analyze existing case decisions and IRS rulings before advising a client who faces these challenges.

Rulings in Favor of the Taxpayer

A number of cases involving partnership issues (and similarly, corporate distributions prior to or after an exchange) have ruled in favor of the taxpayer. Notably, Magneson v. Comm., 81 T.C. 767 (1983), aff'd, 753 F.2d 1490 (9th Cir. 1985) has often been used by practitioners to support partnership distribution issues in an exchange. In this case, Magneson exchanged a fee simple interest in real property for a 10% undivided interest in other real property. On the same day it was received, the tenant in common interest was contributed to a partnership for a 10% equity interest in the partnership. The IRS attacked the exchange, on the grounds that Magneson did not hold the replacement property for investment. The court concluded that Magneson "continue[d] to hold [the replacement real estate] for investment, albeit in a different form of ownership." (Id. at 1495). Terry Cuff, in an excellent discussion of this caseⁱ, cautions against relying on its findings, particularly since this was a pre-1984 exchange. He suggests that Congress may have excluded a partnership interest as eligible exchange property in reaction to the Magneson case.

Other rulings favorable to the taxpayer include Mason v. Comm., 55 T.C.M. 1134 (1988), aff'd, 820 F.2d 420 (11th Cir. 1989), in which a partnership distributed property to the partners immediately before its sale, and one partner exchanged his interest for replacement property. This, however, was another pre-1984 exchange. In Bolker v. Comm., 81 T.C. 782 (1983), aff'd, 760 F.2d 1039 (9th Cir. 1985), a taxpayer received property in a corporate distribution. On the same day, the taxpayer entered into a contract to sell the property in a tax-deferred exchange. The exchange took place three months later. Conversely, in Maloney v. Comm., 93 T.C. 89 (1989), a corporation transferred real property in an exchange, and one month after receiving various replacement properties distributed them to the shareholders in a corporate dissolution.

Rulings Against the Taxpayer

Not all taxpayers have met with the successes noted above. A study of Chase v. Comm., 92 T.C. 874 (1989), will reveal how an attempted exchange by a partner failed. The partnership, in which Chase owned a partnership interest, entered into a contract to sell a building it owned. Afterwards, but six months before the sale occurred, the partnership deeded Chase an undivided interest in the property. The deed to Chase was not recorded until immediately preceding the conveyance of the relinquished property to the contractual purchasers. The deed to Chase was not authorized under the partnership agreement, nor did Chase receive income during the six-month period in which he supposedly owned an undivided interest in the property. The IRS ignored the deed from the partnership to Chase, claiming it lacked substance. Robert Crnkovic and Robert L. Whitmire have written a detailed analysis of this case, explaining why Chase's exchange failedⁱⁱ. Further, they provide recommendations for overcoming the mistakes that doomed Chase's exchange.

There are several notable IRS decisions against taxpayers that also deserve scrutiny. Revenue Ruling 75-292 ruled against a taxpayer who failed to meet the "held for investment" requirement as to replacement property when, immediately after receiving replacement property in an exchange, he contributed the property to a corporation for stock. Presumably, a contribution to a partnership or LLC for an ownership interest would similarly fail. Revenue Ruling 77-337 involved a taxpayer who exchanged real property immediately after receiving it in a tax-free distribution upon the dissolution of the corporation in which he was sole shareholder. The "held for investment" requirement was not met by the taxpayer as to the relinquished property. The Service, in Priv. Ltr. Rul. 9741017 (July 10, 1997), ruled against two brothers who held title as tenants in common to ten tracts of land. Each attempted to exchange his 1/2 undivided interest in certain tracts for his brother's undivided interest in the other tracts, resulting in a partition of the properties. Although they owned property as tenants in common, they were deemed partners because they had filed a partnership return, and the IRS ruled that they had exchanged a partnership interest for a fee simple interest. In Technical Advice Memorandum 9818003 (Dec. 24, 1997), an exchange failed when the partnership transferred relinquished property and had its replacement property deeded directly to the partners. Technical Advice Memorandum 9645005 (July 23, 1996) addressed a § 1033 involuntary conversion in which a partnership distributed the relinquished property to the partners one day before its sale, and the partners received various replacement properties. The IRS held that the tenants in common had sold the relinquished property as mere conduits for the partnership and that the tenants in common had never had the benefits and burdens of ownership.

Section 1031 of the tax code has often been used as an example of form-over-substance, because an exchange will fail if diligence is not exercised to comply with each technical exchange requirement. However, these examples illustrate that not only strict adherence to the exchange rules, but also the underlying substance of the exchange transaction will be scrutinized by the IRS. A partner may be sadly mistaken who thinks he has met the requirements of a successful exchange by simply receiving a deed for an undivided interest from his partnership immediately before the transfer of property, exchanging it for like-kind replacement property. However, with careful long-term planning in conjunction with competent tax advice, a partner may be able to take full advantage of the tax-deferment possibilities that a like-kind exchange can offer.

Carol A. Hayden is Vice President of Investors Title Exchange Corporation. She can be reached at chayden@1031itec.com or 800-326-4842.