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Written by: Julie Baird | President, First American Exchange Company
Surprisingly, half of high-net-worth baby boomers, even those looking to downsize, plan to hold onto their wealth during their lifetime. As boomers focus on preserving the wealth that they have built, as well as simplifying their portfolios to better suit the next chapter of their life, many are taking a closer look at their commercial real estate holdings. However, these real estate holdings may sometimes be held in partnerships that might have been formed years or even decades ago.
These types of partnership arrangements can become tricky when looking to sell, transition into retirement, or take advantage of tools like a 1031 exchange — a tool that allows investors to defer capital gains taxes by reinvesting into like-kind property.
What happens when not all partners are on the same page? For example, if one partner wants to cash out, yet the other partner wants to reinvest.
For boomers who have equity tied up in shared properties, figuring out the answer to those questions and navigating those split decisions can sometimes lead to roadblocks in achieving their broader goals around tax planning, liquidity, and long-term financial flexibility. Investors should always consult their tax professional and legal counsel when evaluating their options, but 1031 exchanges may be helpful in this context.
THE PROBLEM WITH PARTNERSHIPS
Partnership structures can complicate 1031 exchanges. First, for 1031 purposes, a sale of a property interest owned through an interest in a partnership is considered a sale of the partnership interest. Under Internal Revenue Code § 1031(a)(2)(D), partnership interests are not exchangeable. Second, the taxpayer that sold the relinquished property must acquire the replacement property.
For example, if a partnership sells the relinquished property to a buyer, that same partnership must buy any replacement property acquired through an exchange. Individual partners may not individually exchange into replacement property with proceeds from the partnership’s sale.
THE “DROP AND SWAP” SOLUTION
A common solution to the above dilemma is for the partners to implement the “drop and swap” strategy. This strategy happens prior to the sale, where the partnership dissolves and distributes individual tenant-in-common (TIC) interests in the property to each partner.
From there, individual owners can decide what is next for each of them. Some may exchange their TIC interest into replacement property, and other partners may choose to cash out and accept the tax consequences.
The drop and swap strategy is not without risk and takes planning in advance, but when implemented with the guidance of a tax advisor or attorney, may allow for greater flexibility and enable each former partner to pursue their own path, while still preserving the opportunity for tax deferral under a 1031 exchange.
SUPPORTING BROADER RETIREMENT GOALS
For boomers who are nearing retirement, preserving capital is often a higher priority than passing down wealth prematurely. With nearly half of high-net-worth boomers intending to retain their assets throughout their lifetimes, real estate — and how that real estate is managed or divested — plays a major role in that strategy.
For those exiting partnerships, a 1031 exchange can support that goal, but can also play a larger role in estate planning. When a property is passed on at the owner’s death, the cost basis is typically “stepped up” to its market value at the time of inheritance. That essentially eliminates deferred capital gains taxes that the owner would have incurred, which means that future tax burdens are minimized for their beneficiaries.
A THOUGHTFUL EXIT
Boomers are currently a very powerful force in the real estate market. They once again outpace millennials as the largest group of home buyers, and they make up a significant share of sellers. But exiting a commercial real estate investment held in a partnership, as mentioned earlier, is not always straightforward.
As partners approach retirement with differing goals, the ability to split strategies — some reinvesting via a 1031 exchange, others cashing out — can offer a smoother, more tax-efficient exit from legacy investments. By planning ahead, consulting with a tax professional and legal counsel, and considering different tools like the drop-and-swap, for example, baby boomers can navigate difficult partnership dynamics and still preserve the wealth they have built.
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