Hidden Dangers of Partnerships and the 1031 Exchange

The Section 1031 “like-kind” exchange is a legal tool utilized by many investors to upgrade their real estate holdings while deferring taxation. Theoretically, investors can exchange properties indefinitely without incurring capital gains tax. However, complications can arise when these investments are made by partnerships. It is almost inevitable that somewhere along the process, a partner will want to “cash out” their investment. This can expose the entire partnership to substantial tax liabilities.

If in order to satisfy the exiting partner, the partnership’s property is sold and proceeds distributed, the remaining investors will be subject to substantial taxation on any gains. Simple strategies, such as “buying out” the exiting member or specially allocating the gain, also subject the partners to taxation. However, several options are available to a partnership facing dissolution. These include the “drop and swap”, the “swap and drop”, the “split-off”, and the installment note. With appropriate planning a transaction can be structured that satisfies both parties.

For partnerships that have seen their dissolution ahead of time, the “drop and swap” can be of great use. In this scenario the partnership makes a tax-free distribution of the investment property’s title to the individual investors. Once the individuals possess title, each investor may “cash out” or make a like-kind exchange. The key to executing this strategy is ensuring compliance with Section 1031’s “held for investment” requirement, thus this strategy requires considerable foresight.

If investors do not recognize the tax issue until just before the property is disposed, a “swap and drop” may be effective. This strategy resembles the “drop and swap” but is ordered differently. Here the partnership executes a like-kind exchange, waits to avoid IRS treatment as a “step transaction”, and then drops title to the individual partners or refinances the new property to acquire cash to redeem the leaving partner.

Alternatively, a “split-off” strategy may be effective. In a split-off, the partnership distributes tenancy in common title to the exiting partner only, then the partnership makes an exchange in its name. Since the partnership keeps title in its name, the split-off provides title continuity, satisfying the “held for investment” requirement and allowing the leaving partner to cash out or exchange their interest.

Finally, the investors may sell the original property for cash and an installment note. In this approach the partnership distributes the exiting partner an installment note equal to his interest while the remaining investors receive cash. The remaining partners use the cash to exchange into a new property and the exiting partner only recognizes gain as note payments are received.

The like-kind exchange provides real estate investors with a valuable wealth-building tool. But if the partnership dissolves, serious tax issues arise. Fortunately, with proper planning these risks can be minimized and transactions can be structured that maximize returns for all the partners.

Aaron M. Gregory, JD/MBA Contributed to this Article.

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The Death of the Estate Tax?

The Estate Tax (or Death Tax), which levies a 45% top tax rate on couples estates valued over $7 million and individuals over $3.5 million, is slated to expire on Dec. 31st. However, it is also scheduled, like a beheaded hydra, to reappear with more ferocity in 2011, with top rates of 55% for estates valued over $1 million. This makes 2010 a weird twilight zone because it will effectively be without an estate tax. Assuming people don’t view this as a can’t miss opportunity to dispose of their parents, there could still be affects on investors and their estates.

Many expect some sort of resolution in the near future as the uncertainty which would be caused through the tax’s expiration would cause much confusion. People would like to know what to plan for, rather than going into the future somewhat blind. However, the debate on just what the resolution will be is currently becoming more contentious. Many on the right favor either imposing an estate tax with rates lower than those currently or abolishing it all together. Those on the left tend to favor higher rates or keeping the status quo. One possibility currently making the rounds is that congress will pass a law keeping the tax at current levels around March and apply it retroactively to the previous months. As it stands right now, the House has just passed a law which would extend the current rates but this has not yet been ratified by the Senate.

If the tax should expire, the estate tax would be replaced by a capital gains tax on all but the first $1.3 million in inherited assets. Heirs who sell those assets would pay between 15 to 28 percent in taxes on any appreciation in value those assets observed from the date they were acquired. Whether or not this situation is more preferable to that of the estate tax most likely depends on the wide range of situations investors may find themselves in. In anycase, it seems the fates of many depend on the political machine in Washington and its eventual decision.

Note: A little known fact is that one of the largest supporters of the estate tax is none other than the life insurance lobby. Why? Because they make a lot of money through selling life insurance policies which provide liquidity for those dealing with estate taxes.

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The 1031 Exchange in Relation to Vehicles

It is widely known that 1031 exchanges apply to different property types, such as office to multifamily or even raw land to oil wells. However there is usually some uncertainty about using a 1031 exchange in the case of vehicles, such as airplanes or boats. The rule of thumb in these circumstances is that 1031 exchanges are acceptable but only within the same asset class. You can trade an airplane for another airplane but not for a boat.

The reasons for exchanging vehicles are slightly less intuitive than those for exchanging real estate assets. The usual purpose behind the 1031 exchange is to defer the tax you incur on appreciation in value in the underlying real estate. Vehicles represent another story, as they rarely appreciate in value. Instead, 1031 exchanges are primarily used with regard to vehicles in order to avoid “depreciation recapture”.

In order to illustrate this point with more clarity, here is an example:

Three smaller trainer Cessna aircrafts from the 1980s were exchanged for a new Cessna. When you buy a plane for 500k, you depreciate it over 5 years to offset its business income. When you get to year 6 your adjusted basis is zero so if you sell you trigger "depreciation recapture" a tax on your 5 years of depreciation. If you buy a plane of equal or greater to 500k, you will defer these gains. Most people "trade up" to get new basis by the amount of the trade up. So in my example you can buy a 650k plane and have 150k "fresh basis".

So here we can see how the 1031 exchange can be of great value to those who own fully depreciated vehicles. This is an important point to remember, as it is often is forgotten, costing many to waste valuable resources on unnecessary taxes.

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LandAmerica Settlement Leaves Guidance on How to Handle Proceeds

Imagine waking up one morning and getting a call from your bank informing you that for every dollar you had, you now have quarters. In other words, there is only 25% of your cash left. This horrible scenario is now dawning over many former LandAmerica 1031 exchange customers and they may have little choice but to accept.

Close to 350 former LandAmerica customers had until November 10 to vote on a plan which would have split the proceeds of a bankruptcy ruling according to the type of 1031 exchange agreement they had in place (A U.S. trustee has filed an objection to the ruling which has delayed proceedings). Customers who set up non-segregated plans would have received only $0.25 for every dollar held, those with segregated accounts would have received $0.70, and those who specified their funds be held in an escrow account would have received $0.97.

The reason this tragedy came about was that those customers in LandAmerica without segregated accounts essentially had their money commingled with other customers’ exchange assets. This cash was then used for investment purposes, in this case, auction rate securities which eventually were frozen. As unimaginable as it may seem, this sort of account process is commonplace among many large corporations who facilitate 1031 exchanges. Once your money is handed to them, unless you have asked the question or direct the QI yourself, your cash is dumped into the communal pool of assets. More importantly, you have the worry that the exchange group does not have any knowledge of where the money is held. Your money may be wired to “Treasury Services” such as what happened at LandAmerica.

What has emerged from this case is that you can obtain the same protection for you assets by having the appropriate contract language in place and making sure your proceeds are in separately identified accounts (which ES Group uses 100% of the time). Had this been done, LandAmerica customers would have been able to obtain higher recoveries. Of course, hindsight is always 20/20 and this provides little consolation to those who have seen their wealth disappear. Cases like LandAmerica demonstrate who you do business with and how you do it, is of paramount importance.

At Exchange Solutions Group, we have always ensured our customers’ investments were safe through allowing customers to identify their own bank in which their money will be held. Though it may seem obvious, this option is not available at most other 1031 exchange corporations. By allowing customers to choose their own bank we allow them to introduce a third party (a banker) who is separate from the exchange and can ensure their investments are alone in a separately identified account. The essence of the 1031 exchange is to defer capital gains taxes and continue your investment; this becomes a failed strategy if it’s derailed by poor corporate decision making, or alternatively not knowing what pitfalls to lookout for!

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