A General Guide to Tax Deferred Exchanges
By: P. Patrick Ashouri, Esq.

Partnership Exchanges and IRC §1.761-2(a) Elections

The Tax Reform Act of 1984 made it very clear that partnership interests cannot be exchanged and qualify for deferred gain treatment under IRC §1031. The regulations also interpret no difference between general partnership interests or limited partnership interests. Although actual partnerships can exchange with other partnerships under §1031, the exchange of an individual interest is prohibited.

However, the Omnibus Budget Reconciliation Act of 1990 did amend IRC §1031 to incorporate the use of IRC §1.761-2(a), Election of Partnerships, to not be treated under Subchapter K of Chapter 1 of the Code, for the purposes of taxation. This means that §1.761-2(a) can potentially provide an avenue to utilize §1031 to those investors currently owning partnership interests.

So, how does an election under §1.761-2(a) provide a benefit to the typical investor? Well, if every individual or entity within a partnership, elects to have his individual interest treated as his or her own real property interest, similar to a tenant in common interest, then that individual interest can qualify to be exchanged under §1031. And since that partnership interest can qualify for deferred gain treatment, the amount realized from the sale of that interest can be used to acquire any qualifying replacement property.

Therefore, an interest from a partnership in which all partners have made individual elections under §1.761-2(a) can be exchanged for any other property. And, there is no requirement that the investor exchange into replacement properties with his or her previous partners, only that the exchange be used for investment purposes only and not for the active conduct of a business.

Also, the converse of the above §1.761-2(a) situation is possible. It is permissible for a partnership to acquire a property and elect to have the partnership interests treated as individual real property interests for taxation purposes, at the time of purchase. Therefore, as seen in some sophisticated transactions, particular partnerships which have already ready elected under §1.761-2(a), may be established for the sole purpose to solicit investments from other partners exchanging out of one partnership (with the benefit of §1.761-2(a)) into the new entity. This process enables the Exchangor to exchange out of one previously non-qualifying exchange investment, into one, which provides little or no management and superior cash flow or other benefits.

This strategy can also be used for business assets. In both cases however, it is important to outline the goals and objectives of all parties involved in the exchange.

It should be noted that in every case involving an election under §1.761-2(a), it is critical to evaluate the status of your election and exchange with the advice of a qualified tax professional. They will relate your situation to specific Internal Revenue Letter Rulings and other interpretations, which could assist in the strategic structuring of your transaction.

Constructive Receipt

The issue of constructive receipt is one that continues to concern taxpayers, their accountants and tax advisers alike. Over the years that the public has benefited from tax deferred exchanges, various elements of control have been reviewed by the courts in attempting to determine whether the taxpayer has in fact exercised sufficient control over the proceeds from the disposition of the relinquished property so as to be considered in receipt of such funds and thereby taxed.

Clearly if a taxpayer receives the proceeds from the disposition of his relinquished property, the use of terms "exchange" or "relinquished property" have no meaning since the transaction will be viewed as a sale and the taxpayer taxed accordingly. Where someone other than the taxpayer receives and controls the use of the proceeds from the disposition of the relinquished property, the relationship between that person or entity and the taxpayer is closely scrutinized to determine whether or not it is so closely related to the taxpayer that it can be considered that the taxpayer has constructively received the funds.

Selecting Your Facilitator

There are virtually no state or federal regulations governing the function of facilitators, other than the fiduciary responsibilities that govern the conduct of any entity holding or handling other people's money. For this reason, care in selecting a facilitator for you or a client's exchange is an important process of evaluation. Select the facilitator as you would an attorney for personal representation or a physician to treat your children. Look for experience in doing exchanges and reputation in the real estate, legal or tax communities.

Talk to escrow and closing professionals that handle exchanges and get their opinion. If possible choose a facilitator who is thoroughly familiar with the process, since many times other aspects of the process will bear significantly on your exchange. For instance, the handling of Promissory Notes, bulk transfers or other variations. Ask the facilitator if their firm handles reverse exchanges. If they do not, the company and its personnel may not be adequately experienced. Ask about the security of your funds, and what options you as an Exchangor may have to assure that your funds will be safeguarded.

Although the costs and fees for an exchange are relatively insignificant, ask about them, and get a clear explanation of what you will be charged. With a few notable exceptions, fees are very similar, one facilitator to the next. What is of far greater importance is the competence and ability of the facilitator and its personnel to complete your exchange promptly, professionally and legally.

Tax Consequences of Exchanging

In order to assess the tax consequences inherent in any exchange transaction, it is first necessary to understand the definition and exchange related meaning of terms such as Cost Basis, Adjusted Basis, Capital Gain, Net Sales Price, Net Purchase Price and Boot.

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