A partnership may undertake a tax-free exchange on qualifying assets it owns, but the 1984 Tax Reform Act excluded a partner's interest in a partnership (IRC 1031(a)(2)(D) from a tax-free exchange transaction.
Even though partnership interests may not be exchanged, if an interest in real property is distributed to a partner who then completes the exchange, the exchange may qualify as a tax-free exchange.
In Magneson v. Comr., [753 F2d 1490 (9th Cir. 1985] a majority of the Tax Court determined that the taxpayers' exchange of property (the "first property"), which they had held for investment , for a 10% undivided interest in like-kind property (the "second property"), qualified for tax-free treatment under Code Section 1031(a) where, pursuant to a prearranged plan, the second property was contributed to a partnership in exchange for a 9-10% general partnership interest. The majority opinion focused only on the issue of whether the taxpayers had met the statutory requirement that the second property be "held" for investment or for productive use in a trade or business. After analyzing the facts, the Tax Court found that the taxpayer's relationship to the acquired property was not changed by the contribution of the second property to the partnership, and concluded that the "holding" requirement had been met.
The Ninth Circuit, affirming the Tax Court, found that the holding requirement had been met and that, even if the transaction were characterized as an exchange of a fee interest in the first property for a general partnership interest, the exchange (which occurred before the effective date of the 1984 TRA changes to Code Section 1031(a) would still qualify for like-kind treatment because the general partnership interest was of "like-kind" to the fee interest in the first property. The Ninth Circuit suggested that a different result would be reached if the taxpayers had contributed the second property to a partnership in exchange for a limited partnership interest or had contributed the second property to a corporation in exchange for stock.
The Ninth Circuit also attempted to narrow its holding, to limit the potential impact of its decision, by stating that it was meant to apply only to cases where the property received in an exchange was transferred to a partnership in exchange for a general partnership interest, where the partnership's assets were predominantly of like-kind to the taxpayer's original investment, and where the purpose of the partnership was to hold the property for investment.
Under the Ninth Circuit's narrowly drawn decision, like-kind treatment was available to certain taxpayers who exchanged investment or business property for like-kind property with the intent of contributing the acquired property to a partnership in exchange for a general partnership interest, although the exclusion in the 1984 IRA of partnership interests from qualifying under Code Section 1031 generally may have rendered this treatment obsolete for transfers after July 18, 1984. In any event, such taxpayers had to prove that the purpose met the requirements of Code Section 1031(a) and that the assets of the partnership were predominantly of like-kind to the taxpayer's original property. For transfers occurring after July 18, 1984, the general effective date for changes to Code Section 1031(a) as they apply to exchanges of partnership interests, such taxpayers must convince a court that the "step-transaction doctrine" should not be applied to recharacterize their transactions as an exchange of real property for a general partnership interest, although this might be a difficult tax where the transfer to a partnership was part of a prearranged plan.
Similarly, in Bolker v. Comm'r, [760 F 2d 1039 (9th Cir. 1985)], the Court held that a shareholder receiving real estate in a tax-free Section 333 liquidation could immediately do a tax-free exchange of the real estate. Since the liquidation was tax free, the shareholder was deemed to have a continuing interest in the real estate from his former ownership of all the stock of the liquidated corporation.
Therefore, based on the Bolker and Magneson cases, distributions of real estate tax-free by a partnership to a partner may be exchanged by the partner for other real estate. However, the transaction must be structured carefully such that the property is actually distributed by the partnership to the partner. For example in Delwin G. Chase, [92 T.C. 874 (1989)], partners attempted to distribute real estate to themselves by deeding the property to themselves from the partnership without recording the deeds. The court held that the partnership and not the partners had sold the property and exchange treatment could not be obtained.
In 1990, Congress amended Code Section 1031(a)(2) which provides that an interest in a partnership that has in effect a valid election under Codes 761(a) to be excluded from the application of Subchapter K will be treated as an undivided interest in all of the assets of the partnership. Therefore, such exchange of the partnership interest may be valid.
Example: A and B form partnership AB to own land X. A and AB are equal partners and decide to elect out of the provisions of Subchapter K. Therefore, A and B are each treated as owning an undivided 50% interest in X and A may exchange his partnership interest for other real property.
Conclusion: If the exchangor receives replacement property in a tax-free exchange and desires to contribute it subsequently to a partnership, there appear to be two alternatives. Rather than contribute the property to a partnership, hold the property as an undivided interest and have the managing partner conduct operations under a management agreement. It would seem that a second option would entail forming a partnership under applicable state law but for federal income tax purposes, electing out of subchapter K (the partnership section of the Internal Revenue Code) in a manner prescribed in Regulation 1.761-2.
In order to elect-out of subchapter K, the regulations require that the activity be of an investment nature rather than a trade or business. In the definition of a partnership in regulation 1.761-1, we are told:
Mere co-ownership of property which is maintained, kept in repair, and rented or leased does not constitute a partnership.
Also:
Tenants in common, however maybe partners if they actively carry on a trade, business, financial operation, or venture and divide the profits thereof. For example a partnership exists if co-owners of an apartment building lease space and in addition provide services to the occupants either directly or through an agent.
It would then appear that mere maintenance of real estate does not create a Trade or Business but once you start to provide services to the tenants such as providing meals, maid service, laundry and transportation you then have a Trade or Business.
For additional requirement of the election not to be treated as a partnership for tax purposes, please refer to regulation 1.761.2
If you have a sizable transaction and wish to rely on an election under regulation 1.761-2 to provide for like-kind property, it would probably be prudent to request a private letter ruling for your transaction. Your attorney or accountant may request for such a written ruling from the Internal Revenue Service.