Can Partners do Separate 1031 Exchanges by Becoming Tenants in Common?

In recent years there has been a growing perception that the IRS may be adverse to Section 1031 exchanges that occur proximate to a partnership dissolution and subsequent liquidation into tenants in common (TIC). This perception has been fueled by the inclusion in 2008 of questions 13 and 14 in Form 1065 which suggest the IRS is on the lookout for these transactions. However, despite the possible inference drawn from Form 1065, the drop and swap technique is still viable in most instances. If properly planned and executed, partners should be able to become TIC. As TIC, they should do separate exchanges since a tenancy in common interest qualifies as real property for purposes of IRC Section 1031. Of foremost concern is the resemblance of an exchange of a TIC interest to an exchange of partnership interests, which would not qualify for nonrecognition of gain under Section 1031(a)(2)(D), which denies such treatment to exchanges of partnership interests. A TIC is not a partnership interest - it is direct interest in real property. A tenancy in common may be treated as "in substance," an interest in a partnership depending upon the nature of the property and the underlying relationship of the co-owners. This is a form over substance determination. Partnership vs. Tenancy in Common Many features of a partnership (or limited liability company) are typically absent in a tenancy in common. For example, an agreement as to centralized management and decision making by a majority or other voting percentage, sharing of profits and losses other than on a strictly pro-rata basis, and limitations on transferability of interests are typically absent from a tenancy in common arrangement. The effect of a TIC is that every TIC owner, no matter how small its ownership percentage, has an equal vote. Revenue Procedure 2002-22 sets forth the key criteria for being regarded as a tenancy in common - however, by its terms, that pronouncement does not apply to a tenancy in common among former partners. Timing is key A drop and swap transaction is more likely to be respected if the drop into TIC occurs long in advance of beginning to negotiate the sale of the property. The parties must be sure to reflect the tenancy in common in all accounting records and to change their relationship to that of TIC. Some departure from the criteria in Rev. Proc. 2002-22 may be permitted but this increases the risk of a successful tax challenge. A key question is whether a tenancy in common can be created after the property is in contract. If the drop occurs after all negotiations have been completed at the partnership level, it is more easily subject to attack. It is better to drop into TIC before the negotiations have been consummated. Nevertheless, even after the negotiations are far along, it may still be possible to drop into TIC for tax purposes if (i) there are still ongoing negotiations of consequence and/or (ii) the partners were in the process of dissolving their partnership before the negotiations commenced - or even were consummated. This is a factual determination that should be documented. Transactions planned at the 11th hour can be risky. However, with proper planning and implementation they may still be viable. Seek the advice of counsel thoroughly versed in the subtleties of the governing tax authorities. Merely calling it a TIC may not be enough. Stephen Breitstone is partner and head of tax practice and Mark Wilensky is counsel to the tax law group at Meltzer, Lippe, Goldstein & Breitstone, Mineola, N.Y.