1031 exchange help!
I am considering selling a rental property and appling the proceeds towards a partnership purchase of a new property. My partner would consider the new property their primary residence, however I would need this property to be reflected as a rental.
Is this possible? If so, what would be the best approach to reporting taxes as a result of what I would consider income and what my partner would consider principle and interest paid?
mplemons,
When you say "partner", I assume that you really mean a shared ownership/co-borrower arrangement, instead of a partnership business entity participating in this transaction.
If so, then each of you will treat the purchase of your share of the property differently. Even though only one property is actually involved, look at this as two separate deals. Your "partner", who lives in the house, will be purchasing a primary residence, while your share of the purchase will be an investment property.
Charge your "partner" a fair market rent for your share of the property (or put your own tenant in your share of the property), then report income and expenses on Schedule E and take a depreciation expense.
When the property is sold, your partner's share of the profit may be eligible for the capital gains exclusion on the sale of a primary residence, while your share of the property is treated as the sale of investment property (subject to capital gains and depreciation recapture).
Since you mentioned 1031 exchange in the title of your post, I assume that you want to defer capital gains from the sale of your rental property and purchase this property as a replacement property in a 1031 exchange. No problem, but the exchange umbrella will only cover the portion of the "investment" property that you will own. May also be a good idea for you to each have separate deeds for your respective shares of the property.
Now with all that having been said, I would challenge the wisdom of participating in this purchase. Each of the "partners" in this transaction has a different goal. What if you want to sell your share of the property but your "partner" doesn't? What if something happens to your partner and his/her heirs refuse to cooperate with you on the sale of the property, or refuse to pay their share of the mortgage payment?
Before taking any action, it would be an excellent idea to discuss these concerns and other potential pitfalls in this transaction with your own attorney.[ Edited by DaveT on Date 04/25/2003 ]
DaveT,
Thanks for your insight. Your assumptions are all accurate and I agree with your concerns regarding seperate agendas within the partners.
However, in this case my "partner" would actually be my son as I am trying to help him into a home. Given this would you have any other suggestions and/or recommedations?
THanks!
Instead of what you propose, why not take the obvious course of action? Rent your investment property to your son for a fair market rent. Then when he is in a position to buy it from you, let him do so with his own financing.
This would let you preserve your rental income stream without resorting to a 1031 exchange.
My questions relates to this post, but I'll ask it on a more general level first as it concerns to 1031 exchanges and partnerships. Can a partnership be entered with exchange properties involved? In other words, if one partner is simply buying a 50% share and the other partner seeks to buy their 50% share as a replacement property in a 1031 exchange, can this be done despite the fact that the replacement property is bought as part of a partnership and the original property was owned by a single party? My partner has been advised that this is not possible, that they can only do an exchange for like kind property (investment, in this case land exchanged for a rental) only in their name. Are they getting bad advice? It seems to me that if this were the case, then any partnership purchases could not involve exchanges going into the deal or coming out of it, unless both parties stay partners. That would mean that if you sell your interest in the property, you would be ineligible for an exchange to a new property unless you did it with your existing parter. This just doesn't make sense to me. Dave, what you said in this post about each partners share seems much more logical to me, but who said the tax law is always logical. Can you clarify for me? Thanks![ Edited by Chris2003 on Date 04/28/2003 ]
The 1031 like-kind exchange rules do not apply to an exchange of interests in a partnership (whether general or limited partnership), regardless of whether the interests exchanged are interests in the same partnership or in different parnerships. The assets owned by the partnership are irrelevant.
For example, let's say you want to exchange your 50% partnership interest in a $400,000 rental office building in New Orleans, LA for a 50% partnership interest in a $400,000 rental office building in Clearwater, FL. You have reported all your income or loss from this rental (from your K-1), and the office building has been reported on a partnership tax return (Form 1065). According to Section 1031(a)-(1)(a)(1) of the tax code, your exchange is a taxable transaction.
I suggest that you consult your personal tax advisor for specific details.
Chris:
DaveT is right, so I will only add some tidbits. (By the way Dave, I am very impressed with your tax knowledge for a person who is not a CPA or tax attorney. Clearly you have been around the "tax block" awhile and have done your homework on the Internal Revenue Code!).
Chris, while a partnership interest cannot be exchanged for a partnership interest and qualify under Section 1031, remember that the partnership can exchange real estate for other real estate. The "person" exchanging the real estate must be the same on both exchange ends.
If you are in a partnership and your partners do not want to exchange the real estate the partnership owns, rather than have your partners cash you out ofd the partnership (which would be treated as a liquidating distribution against your partnership interest and thus not qualify for Section 1031 treatment), you should have the partnership distribute your pro rata share of the real estate to you first. That can usually be done tax free, depending on the level of debt, whether it is recourse or nonrecourse debt, and your basis in your partnership interest. To effectuate this transfer and prove to the IRS that your share is no longer owned by the partnership, you should have your pro rata share of the property deeded to you (or your single member LLC) as an undivided interest in the real estate. Thus, the deed would read something to the effect of (depending on your state titling laws) "Chris, with X% undivided interest in property A, as tenants in common with partnership, which owns an undivided Y% interest in property A ."
In addition, you want to elect out of the federal partnership tax rules (Section 761 of the Internal Revenue Code). I often draft for my clients a "co-tenancy agreement" to accomplish this. There is a number of requirements that need to be satisfied for the IRS to respect your co-tenancy agreement. There is a recent Revenue Procedure that outlines these requirements. See your tax advisor on these requirements. I would not take this lightly, as I have seen the IRS argue that a partnership exists and they were able to convince a court of that argument, which resulted in the taxpayer losing the benefit of the Section 1031 exchange (it cost the taxpayer over $1M in taxes because they did not do it correctly the first time).
Hope those pointers help,
Taxjunkie