10 Jun Strategies for Exiting or Disposing of Commercial Real Estate Interests—Section 1031 Exchanges

Last week Edwards Law discussed how to exit a commercial real estate joint venture, including the right of first refusal and the right of first offer.  Another important consideration when exiting a commercial real estate venture are the potential tax consequences of exiting the venture and/or selling the real estate.  An important tool in your real estate venture toolbox is the 1031 exchange.  If you are not familiar with it, now is the time to learn about this useful tool, before you enter another real estate venture.  Please note that this article is for informational purposes only and does not constitute tax advice, and Edwards Law cannot provide tax advice or tax services.  Edwards Law advises you to consult a tax attorney if you have specific questions about 1031 exchanges.

The 1031 Exchange

The tax considerations when exiting or disposing of a real property investment depend in part on the type of entity in which the investment is made.  Ideally you and your business partners evaluated early on the benefits of an LLC, which entity typically makes exit strategies easier.

Assuming your real estate venture is structured as a pass-through LLC, you will want to consider a like-kind exchange under IRC Section 1031 (1031 exchange) as a tax-deferred way to exit an investment if you intend to invest in other real estate.  Under Section 1031, real or personal property held for productive use in a trade or business or for investment can be exchanged for other property “of like kind” and the gain or loss on the exchange is generally deferred.  The underlying rationale is that you, as the investor, are not “cashing out” your investment but rather exchanging one investment property for a similar one.

Limitations on 1031 Exchanges

An issue arising in joint ventures is that a 1031 exchange does not apply to an exchange of partnership interests under the Internal Revenue Code.  Even though the partnership is a flow-through entity for tax purposes, the Code considers the holder of a partnership interest to be a holder of personal property, not the owner of a part of the underlying real property.

This means a partner in a partnership cannot exchange its partnership interest in one partnership for a partnership interest in another and qualify for like-kind exchange treatment.  Also, if a partnership distributes real property to a partner to liquidate its interest, the partner most like cannot immediately enter into a 1031 exchange using that property because the property is not to have been considered “held” by the partner for productive use in a trade or business or for investment during the time the partnership held the property.

Avoiding Limitations on 1031 Exchanges

There are ways to avoid these 1031 limitations.  For example, the partnership can purchase replacement property, by completing the 1031 exchange, selling the owned property and buying a replacement property.  After the exchange, the partnership can redeem the partners wanting to exit the investment, and the partners wanting to defer their gains remain in the partnership that owns the replacement property.

The partnership can also dissolve (called a “drop and swap”) and distribute undivided interests in the real property to each of the partners.  After a requisite period of time (usually a minimum of two years), the property is considered “held” for productive use of a trade or business or for investment by each of the former partners.  The former partners can then exchange their undivided interests for replacement property using a 1031 exchange.

Lastly, the partnership could exchange property and dissolve the partnership (called a “swap and drop”). A reverse of a drop and swap, the partnership can exchange its real estate for replacement property. The partnership holds the replacement property for a requisite period of time (usually a minimum of two years).  The partnership then dissolves and distributes the replacement property to the partners.

Non-Recognition Exception to FIRPTA: Non-Simultaneous 1031 Exchange

The Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”) mandates that gain or loss from the sale of US real property interests by a foreign person be taxed as if the foreign person were a US person. The FIRPTA rules impose reporting requirements on those involved in the sale of the real property interests to make sure any gain by or loss to a foreign person is properly accounted for by the US tax system.  While there are exceptions to the rule, if the foreign person sells a US real property interest, FIRPTA generally imposes on the purchaser a withholding requirement of 15% of the amount realized on the sale.

However, no FIRPTA withholding is required if a foreign seller qualifies for non-recognition treatment under one of the provisions of the Code.  Also the FIRPTA rules are different if the foreign seller engages in a non-simultaneous like-kind 1031 exchange. In that case, the seller must obtain a withholding certificate from the IRS.  If the IRS certificate is obtained before completion of the transaction, the purchaser (which is typically a qualified intermediary in a 1031 exchange) is not required to withhold any part of the transaction proceeds.

State Transfer Tax Considerations for 1031 Exchanges

Many states impose transfer taxes on the transfer of real property and partnership interests in a partnership that owns real property.  In some cases, transfers by a 1031 exchange are exempt from transfer tax.  These exemptions vary from state to state and are outside the scope of this article.

It is important to engage the services of a CPA or tax attorney before attempting any of these tax deferral techniques.  If you need help navigating the world of 1031 exchanges, call Edwards Law today for free consultation about your options.