Entity Planning When Selling a Farm or Ranch: Partnerships, LLCs and the 1031 Exchange
It’s common for farm and ranch real estate to be owned by a partnership or limited liability company (LLC). Owning real estate in either of these entities can present challenges when the property is sold and the partners/members have different reinvestment goals, particularly if certain partners/members want to defer tax by completing their own 1031 exchange into other real estate, while others want to simply cash out and pay the tax. In this situation, proper planning must take place to provide the partners with optimal flexibility.
Why Advance Planning Matters
When a partnership owns real estate, the partnership is the property owner -- not the partners. The partners own interests in a partnership -- and these partnership interests are considered personal property and do not qualify for 1031 exchange treatment.
The IRS rules governing a 1031 exchange dictate that the entity selling the relinquished property must be the same entity taking title to the replacement property. Accordingly, when real estate is owned and sold by a partnership or LLC, that partnership or LLC must complete the exchange. The individual partners/members are prevented from completing their own personal 1031 exchange.
So what is the solution? This article will discuss several potential options that may allow those partners who wish to complete a 1031 exchange to do so. These strategies also apply to members of LLCs.
Drop and Swap
Prior to the sale, the partnership could distribute the ranch real estate out of the entity to the partners individually, who would then own the real estate as tenants-in-common. Effectively, rather than owning an interest in a partnership that owns the real estate, each partner would individually own a fractional interest in the property. This fractional interest does qualify as like kind property -- thus, each individual could do as they pleased upon the sale, independent of the other partners, including completing a 1031 exchange or taking cash. This strategy is often referred to as a “drop and swap.”
To help ensure this strategy complies with 1031 exchange rules, the distribution of property from the partnership should be done well in advance of the sale. Ideally, the distribution would occur well before the property is listed for sale, and the partners would hold the distributed property for two years prior to its actual sale. At a minimum, the property distribution and eventual sale should occur in separate tax years. The reason is this: To qualify for 1031 exchange treatment, property must be held for investment purposes or used in a taxpayer’s trade or business. Property held for resale does not qualify for tax deferral treatment. If the partners waited to distribute the property out of the partnership too near the time of the ranch sale, the IRS could take the position that the partners held their fractional interests in the relinquished property for resale, thus disqualifying the property for 1031 exchange treatment.
Swap and Drop
If the ranch sale closing date is close at-hand and the real estate still has not been distributed out of the partnership, it may be wise to consider an alternative strategy commonly referred to as the “swap and drop.”
Using this strategy, the individual partners who wish to complete a 1031 exchange would identify individual properties they wish to trade into. The partnership would close the sale of the ranch and complete the exchange into the identified replacement properties. The partnership would then maintain ownership of these properties for a reasonable period of time (two years is recommended), and then later distribute the applicable properties from the partnership to the respective partners.
Another option would be to have the partnership exchange into a replacement property and then later reorganize so that the partners owned fractional interests in the property as tenants-in-common. The property could then be sold and the tenant-in-common owners could exchange their tenant-in-common interests into their own replacement properties. Proper holding period protocol should be followed throughout this process.
Section 761(a) Election
Section 761(a) of the Internal Revenue Code effectively allows an ownership group to avoid being taxed as a partnership and instead treats the individual owners as owning fractional interests in the assets of the partnership (i.e., tenants in common), rather than owning interests in the partnership. As described previously, fractional interests in assets owned by a partnership qualify for 1031 exchange treatment, and the individual tenants in common are each free to exchange into other like-kind property.
There are various restrictions that make Section 761(a) somewhat difficult to comply with, and you should consult with your tax advisors for details unique to your particular situation.
Purchase Partner’s Interest Prior to Exchange
If certain partners wanted to take cash and go their own way, while others want to remain partners and complete a 1031 exchange, the partners who wish to remain might consider buying out those who wish to part ways. Prior to the sale of the ranch, the partners who wish to complete a 1031 exchange could contribute cash to the partnership to be used to buy out the exiting partner’s interest. The existing partnership would then complete the exchange.
Exchange and Refinance
Refinancing offers another strategy for enabling some partners to exit, while others remain partners and benefit from a 1031 exchange. The partnership could sell the ranch and complete the 1031 exchange into replacement property, then refinance the replacement property after a reasonable period of time. The cash from the refinance could then be distributed to the partners who wanted to cash out, and the remaining partners would continue in the partnership having achieved their tax deferral goal.
Form 1065: Facts You Should Know
As evidence that the IRS is looking for tax shenanigans related to abuse of Section 1031 of the Internal Revenue Code, taxpayers must disclose on Form 1065, U.S. Return of Partnership Income whether the partnership:
- distributed any property received in a like-kind exchange or contributed such property to another entity. This is relevant in the event that the partnership previously completed a “swap and drop” strategy, whereby the partnership received property in a like-kind exchange and has distributed this property to partners or contributed it to another entity. The test here is whether the property has been held for investment since the property was received in a like-kind exchange.
- distributed to any partner a tenancy-in-common or other undivided interest in partnership property. This is relevant in the situation where the partnership and its partners are carrying out a “drop and swap” strategy. The test here is whether the property will be held for investment purposes.
Before any distribution of real property is made from partnerships or LLCs, the partners’ tax advisors should be consulted to determine if the distribution would have income tax ramifications to the partners.
Generally speaking, just because partners or LLC members have divergent goals following the sale of ranch real estate does not mean all partners/members will have to pay tax. Solutions do exist. The key is for the property owners to be proactive and know enough to seek out competent advice for their specific situation well in advance of the ranch sale. Tax advisors should be consulted prior to implementing any of these strategies.
We’ve provided the information in this Straight Talk guide for general educational purposes. It is not intended as specific tax or legal advice. Please consult a professional for specific advice regarding your particular situation.
© 2018 Jack Sauther & Diana Sauther