In a 1031 exchange involving a Delaware Statutory Trust (DST), partnerships have unique considerations when it comes to the purchase and sale of real estate. Here’s a detailed breakdown of how partnerships can manage this process:

  1. Understanding the 1031 Exchange with a DST

A 1031 exchange, under Section 1031 of the IRS Code, allows real estate investors to defer capital gains taxes by reinvesting proceeds from the sale of one property into another “like-kind” property. A DST is a legal entity created as a trust, allowing investors to hold fractional ownership in professionally managed real estate.

  1. Challenges with Partnerships in a 1031 Exchange

Partnerships present specific challenges in a 1031 exchange because of the IRS rules around ownership. Here’s why:

  • A partnership is considered a single entity by the IRS, so it can conduct a 1031 exchange as a unit.
  • However, if individual partners wish to pursue different investment strategies (e.g., some want to do a 1031 exchange, and others want to cash out), the IRS might not allow the partnership to easily split.
  1. Solutions for Partnerships in a 1031 Exchange

There are several methods partnerships can use to handle the purchase and sale of real estate within the context of a 1031 DST exchange:

  1. Drop and Swap Method

In this approach:

  • Before the sale, the partnership is dissolved, and the individual partners take direct ownership (tenants in common or TIC) of the property.
  • Each individual partner then has the option to do their own 1031 exchange (including into a DST) or cash out if they choose.
  • This method is often complex and subject to IRS scrutiny, as it must be done correctly and ahead of time to avoid being viewed as a tax-avoidance strategy.
  1. Swap and Drop Method
  • In contrast to the drop and swap, in the swap and drop method, the partnership first completes the 1031 exchange as a partnership and then, afterward, dissolves, distributing the newly acquired property to the partners as tenants in common or individual owners.
  • While this defers the issue, it can be risky as the IRS might view this as an attempt to avoid taxes.
  1. Using a DST to Resolve Disputes Among Partners

For partnerships that want to stay together or individuals that prefer a hands-off approach, a DST can be an attractive solution. Here’s how it works:

  • The partnership sells the relinquished property.
  • Instead of buying new property directly, the partnership reinvests the proceeds into a DST. This gives the partnership fractional ownership in the DST’s portfolio of real estate.
  • The DST is passive, meaning the partnership doesn’t need to actively manage the property, but still enjoys the benefits of tax deferral under a 1031 exchange.
  • If partners are aligned on wanting passive income and tax deferral, this option can simplify the process without dissolving the partnership.
  1. Partial 1031 Exchange
  • Some partners may want to cash out while others want to continue reinvesting. In this case, the partnership can allow the cashing-out partners to receive their portion of the proceeds (subject to capital gains taxes), while the others perform a 1031 exchange into a DST or another property.
  • This option requires careful legal structuring but allows the partnership to satisfy both sides.
  1. DST-Specific Considerations for Partnerships
  • Asset management: When a partnership invests in a DST, the trust is professionally managed, allowing partners to take a passive role.
  • Liquidity concerns: Unlike direct property ownership, DST investments are illiquid, meaning the partnership can’t easily sell their interest in the DST if partners want to cash out in the future.
  • Non-recourse financing: Many DSTs come with pre-arranged non-recourse financing, which can make it easier for partnerships to meet 1031 exchange deadlines.
  • Suitability: DSTs are typically better suited for investors seeking stable, passive income rather than active management or high-growth properties.
  1. Legal and Tax Consultation

Partnerships handling a 1031 DST exchange should seek guidance from:

  • Real estate attorneys: To ensure the exchange and any partnership restructuring comply with IRS rules and state laws.
  • Tax professionals: To navigate capital gains tax implications, passive activity rules, and any potential IRS audits related to “drop and swap” or “swap and drop” transactions.
  1. DST Advantages in a Partnership 1031 Exchange
  • Simplicity: DSTs allow for passive ownership, which can eliminate disputes over property management in partnerships.
  • Professional management: Since DSTs are managed by third-party trustees, partnerships don’t need to worry about day-to-day management.
  • Diversification: Partnerships can diversify by investing in multiple DSTs, thus spreading risk across various properties.

Handling a 1031 DST exchange as a partnership requires strategic planning, especially when partners have differing goals. Solutions like the drop and swap, swap and drop, or using a DST can provide flexibility, but they involve careful structuring to comply with IRS guidelines. Consultation with legal and tax professionals is essential to ensure a smooth transaction.