A common problem that arises in real estate partnerships is when there is an opportunity to sell and some partners want cash out and some partners want to defer tax by engaging in a like-kind exchange. The trick is to dispose of the property in a way that protects the exchanging partners from any tax on the cash received by the partners that want to cash out.
One solution is to distribute an undivided ownership interest (a “tenancy in common” or “TIC” interest) in the real estate to the partners that want to exchange. This transaction can be effective, but it puts stress on two of the requirements for like-kind exchanges: (i) whether the TIC interest qualifies as real estate and (ii) whether the partner who exchanges property will be considered to have held it for investment or for use in a business prior to the exchange.
A better solution is for the LLC to distribute the TIC interest to the owners who want to cash out (the “cash out members”). The LLC retains a TIC interest for the remainder of the property. After the distribution, the LLC will be owned only by the owners who want to make the exchange. Then the LLC and the cash out members can each transfer their respective TIC interests in the property, with the LLC receiving real estate in exchange for its interest and the cash out members receiving cash. The LLC that conducts the exchange is the historic owner of the real estate, so there is no question of whether it held it for investment or use in a business so provided the other requirements are met this is a good tax-free like-kind exchange. The cash out member receives cash and is the only person that is taxable on it.
Bottom Line: While this is a simple description of a somewhat complicated transaction, it can be very effective for facilitating the receipt of cash by some members and receipt of property in a nontaxable exchange by others. Also, it is important to distribute the TIC interests prior to entering into a purchase agreement.
“The only difference between a tax man and a taxidermist is that the taxidermist leaves the skin.” Mark Twain