1031 Experts: Can you partially sell and 1031 exchange into a partially buy?

Question

I read something along these lines (but correct me if my understanding is wrong): that if you get into a partnership and purchase an investment property (e.g SFR LTR 50%-50% with a partner), and then some years later you sell said property, you can 1031 your 50% into a new purchase.

My question is: if I partner with someone and we buy two SFR LTR properties (let's say on the same 50/50 basis) and then 10 years later the partner wants out of the deal and to cash out his 50% participation (which normally would force a sell of the property or a buy out), can we sell one property and can I do a 1031 exchange my sold 50% to 1031 buy my partners other 50% in the second house and keeping it as an LTR, instead of having to sell both houses?

Or vice versa, maybe I want to get out of partnership, or that particular property or location, can I 1031 my 50% out of the first house (and leave it 100% to the partner) for the other 50% in the second property (which will become 100% mine)? Kind of, we dissolve the partnership (or maybe not, just the joint ownership of two houses), but we each keep a house, without selling taxes?

Dave Foster · Answer

@Costin I., You're absolutely right.  If that LLC sells then it either has to do the 1031 and purchase the new property.  Or it can do a partial exchange and keep enough cash to buy out one partner.  Or it can just sell and then the LLC will have a tax consequence.

In any event the LLC then has to reconcile itself internally by shifting membership interests or whatever.  Generally our clients will choose to dissolve the LLC right before the sale and distribute the property to the former partners as tenants in common.  This eliminates the entanglement between partners and leaves you free to act independently of each other.

Costin I. · Answer

Thanks @Dave Foster. Seems I was writing the reply to Bill at the same time you were writing your answer.

The LLC question was Bill's assumption, I didn't bring that LLC structure in my initial posting because I didn't want to complicate things...but you both are right, it is part of the question (although not from, or not only from the 1031 exchange perspective): what is the best structure to hold these properties?

Dave, what do you think about my #2 point above?

Bill B. · Answer

Go with Dave’s option then. You dissolve the llc and each take one house; then one can sell and own can keep.

Though your first argument doesn’t make sense. If 2 llcs each own half of each house they are both at risk just as if one owned 100% of each. And if the owner did something wrong, only their half of the llc would be at risk, not both houses. But again you should force each owner to have an umbrella.

Lastly: always go with Dave over me, he’s the expert. I’ve only done one basic exchange and Dave did it for me.

Dave Foster · Answer

Thanks for that shout out @Bill Brandt.  @Costin I., the answer is yes you can do all of that.  But there's something that has to happen first.  If you go into a partnership like that (doesn't matter if it's one property or 12) then the entity you set up to own the properties (like a multi-member LLC) is the taxpayer for those properties.  If you sell and 1031 it is the entity that is selling.  And in a 1031 exchange the tax payer has to stay the same.  So the entity has to buy.  That's your problem.

One answer is to dissolve the entity and distribute the properties to each partner as tenants in common (you could give a property to each, or you could each be 50-50 on every property - all depends on how you and your accountant want to set it up).  Once you are tenants in common then you can sell properties and each of you can choose to do a 1031 or take the cash for the % of your respective sales.

There are several variations on this and Bill gave you a couple of them.  But the initial key is that to separate yourselves you first have to get rid of the entity and get into ownership as tenants in common.

Bill B. · Answer

It sounds possible, since you’re not buying what you already own. Other options would be an LLC owns both homes and you each own half the LLC. So the LLC could sell one property. One owner could take all the money while the other owner keeps the remaining home.

@Dave Foster will probably have the answer off the top of his head.

Sean Ross · Answer

@Costin I.

If by partnership you mean a legal partnership (LLC or LP or otherwise), then that legal entity would need to either dissolve (or deed out your 50% to you) prior to sale before you could sell your own 50%.

In order to do any 1031 exchange, the same tax filer has to complete both legs of the exchange. This means that if a multi-member LLC is on title to a property and sells that property, only that same LLC can engage in a 1031 exchange.

If you and your partner want to maintain flexibility, you should set up your ownership as two Tenant In Common owners with an undivided 50% ownership each in the properties.  Each of you will report 50% of the property on your individual tax returns.  (Alternatively, you could set up a single member LLC to own your 50% of the properties).  Under this structure, you could sell and 1031 exchange your 50% without implicating your partner at all -- they could exchange with you, exchange without you, or cash out.

If you were both two members in an LLC, which is very common, and you wanted to go separate ways, which is also common, then you would probably want to go through a "drop and swap" process.  This looks like:

- dissolve your LLC - file a final tax return for the LLC - distribute out the LLC's assets pro rata to each member (this is a tax-free distribution) - each member takes title to an undivided interest in the properties in a TIC structure - then you can sell

We deal with this sort of thing literally every single day of the year.  Frankly, there are plenty of other small details that matter here.  There are also a few other possible strategies to deal with it.  I'll send you a connection request and you can message me directly as you think through this.

Sean Ross · Answer

Remember @Costin I. that for any liquidating distribution of a partnership, such as the LLC, the distributions should be done pro rata.  Unless your two properties are exactly the same value, deeding one house to each of you is not going to result in a pro rata distribution.  If it isn't pro rata, then you end up with a partial sale from one partner to the other, which creates tax consequences.

Costin I. · Answer

Thanks @Bill Brandt for your reply.

I see two possible problems with your LLC suggestion:

1. One LLC owning both homes could be problematic for liability purposes. If something is happening with one house, the other is also in trouble. If one partner does something, it puts the other partner in trouble too. For a scenario like this, I think it's better each partner to have own LLC, and the two LLC own the house(s) as TIC.

2. Since the LLC has to sell, there is the potential for capital gain taxes, and likely on both houses. Just because there is an internal agreement between partners, one house gets sold and there can be taxes to pay, by both partners. I don't think it's just an internal transaction and a wash in IRS eyes, nor same as a 1031.

1031 Experts: Can you partially sell and 1031 exchange into a partially buy?

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