*Note: This Week In Tax will not be publishing next week. Happy Thanksgiving and enjoy your holiday!
It seems like every week we get some variation on this question: our partnership is selling its property, we want to do a 1031 exchange to defer the gain but some partners want to take their cash and leave. It doesn’t seem unreasonable but the interplay of the partnership tax regulations and the rules for 1031 exchanges makes it difficult to accomplish.
By way of background, Internal Revenue Code Section 1031 covers the exchange of real property held for productive use in a trade or business or for investment for similar property. No gain or loss is recognized unless you receive cash that is not reinvested in the replacement property.
The common way of dealing with partners who do not want to participate in the 1031 exchange is known as the “drop and swap” or, occasionally it’s inverted cousin the “swap and drop.” These transactions, which involve creating and distributing fractional interests in partnership property, can be complicated, involve additional legal expenses and, depending on jurisdiction, recording fees or taxes.
If the partnership were to some use cash from the sale to “cash-out” partners and use the remaining cash with Qualified Intermediary (“QI”) to buy the replacement property, all the partners would be allocated taxable gain, not just the partners receiving the cash (boot). This is not an optimal solution for the partners remaining in the partnership after the exchange.
As an alternative, the partnership can exchange the property for cash and an installment note. The replacement property is purchased with the cash deposited with the QI and the installment note is distributed to the partner who wishes to withdraw from the partnership. This arrangement is known as a partnership installment note (“PIN”) transaction.
The PIN transaction has two key advantages:
- Cash is used to acquire the replacement property and the buyer of the relinquished property pays the installment note holder directly. Only the redeemed partner recognizes any cash boot. The remaining partners do not recognize any gain from the payment to the retiring partner.
- The second advantage is to delay some of the gain until the final payment is received. The note will often be paid in two installments using cash from the sale of the relinquished property. Any gain recognized is taxed only when the principal payments on the note are received. Therefore, depending on when the relinquished property is sold, the PIN method might delay recognition of gain until the succeeding tax year.
In the right situation, the PIN arrangement can be effective in cashing out partners who do not want to participate in the 1031 exchange. Contact your Friedman LLP advisor for help with PIN or other transaction structuring questions.