If a partnership does a 1031 exchange into 2 rental homes and then decides to distribute them to the partners can the partners qualify for a 121 each?  This is assuming each partner lives in a house for 2 of the 5 years.  When does the 5 years begin?  When the 1031 exchange was done or when it was distributed to qualify for the 121?

@Leah Dockter , Several questions there.

1. Can a partnership entity dissolve and distribute properties to the partners that were formerly 1031d into by the partnership entity - Yes. In general contributions into and distributions out of an entity do not create a taxable event.  Make sure your accountant is quarterbacking it so there's not an inadvertent recognition of gain.

2. Can the partners move into the properties once they have been distributed - Yes.  The way in which they use them is up to them.

3. Can the partners get the full 121 benefit after living in the properties for 2 out of the 5 years prior to sale - No (but a qualified no).  You can read my story of how I did exactly this combination of 1031 to 121 and ended up with the sailboat of my dreams raising my family on the sea for a decade at www.the1031investor.com .  But that was prior to 2008.

Since 2008 the full 121 exemption is no longer available.  But it can still be very beneficial.  Your question is very interesting because it is the partnership that did the 1031 exchange.  The partners may not be required to adhere to the IRS requirements for conversion of an investment property since they were simply given the properties in exchange for membership interest in the dissolved company.  I'll let our esteemed CPAs battle that one around.

Conversions when done by individuals since 2008 have some different rules that you would want to be aware of if they apply to dissolved partnership property.

1. When the property converted to primary residence was once a part of a 1031 exchange the owner has to have owned it for a minimum of 5 years.

2. the owner still has to have lived in it for at least 2 out of the 5 years prior to sale.

3. The owner now only gets to prorate the tax free gain between periods of qualified use (actually lived in as primary) and non-qualified use (periods of investment use).  So if they converted it and rented it for 2 years and then lived in it for 3 they could exempt 3/5ths of the gain tax free.

4. All depreciation must still be recaptured.

But I'm still intrigued to hear some CPA responses to this because I think that the above 4 items might not be factors because the investment use and depreciation were all taken by and part of the ownership by the now defunct partnership entity.  The new owners are not really converting a property.  They are simply using a property that they own in a certain way (if they moved into it immediately).  

Love the question.  And really loved taking advantage of the pre 2008 rules.  

@Nicholas Aiola , @Natalie Kolodij , @Ashish Acharya , @Basit Siddiqi , @Linda Weygant

This one's scurrying around in my brain and you know I'm going to hit you guys up privately to discuss this!  This situation could be a bit of a game changer for folks wanting to exit 1031 land with more tax free dollars.

If an entity owns property and 1031s and subsequently dissolves and distributes the property to the members do those members inherit the requirements of a conversion under 1031.  And do they inherit the non-qualified use time while the partnership was in ownership?

You see where I'm going with this?  It might be possible by using entity ownership to convert property from investment to primary residence and still qualify for the full 121 exemption.  Thoughts???

Originally posted by @Dave Foster :

@Leah Dockter , Several questions there.

1. Can a partnership entity dissolve and distribute properties to the partners that were formerly 1031d into by the partnership entity - Yes. In general contributions into and distributions out of an entity do not create a taxable event.  Make sure your accountant is quarterbacking it so there's not an inadvertent recognition of gain.

2. Can the partners move into the properties once they have been distributed - Yes.  The way in which they use them is up to them.

3. Can the partners get the full 121 benefit after living in the properties for 2 out of the 5 years prior to sale - No (but a qualified no).  You can read my story of how I did exactly this combination of 1031 to 121 and ended up with the sailboat of my dreams raising my family on the sea for a decade at www.the1031investor.com .  But that was prior to 2008.

Since 2008 the full 121 exemption is no longer available.  But it can still be very beneficial.  Your question is very interesting because it is the partnership that did the 1031 exchange.  The partners may not be required to adhere to the IRS requirements for conversion of an investment property since they were simply given the properties in exchange for membership interest in the dissolved company.  I'll let our esteemed CPAs battle that one around.

Conversions when done by individuals since 2008 have some different rules that you would want to be aware of if they apply to dissolved partnership property.

1. When the property converted to primary residence was once a part of a 1031 exchange the owner has to have owned it for a minimum of 5 years.

2. the owner still has to have lived in it for at least 2 out of the 5 years prior to sale.

3. The owner now only gets to prorate the tax free gain between periods of qualified use (actually lived in as primary) and non-qualified use (periods of investment use).  So if they converted it and rented it for 2 years and then lived in it for 3 they could exempt 3/5ths of the gain tax free.

4. All depreciation must still be recaptured.

But I'm still intrigued to hear some CPA responses to this because I think that the above 4 items might not be factors because the investment use and depreciation were all taken by and part of the ownership by the now defunct partnership entity.  The new owners are not really converting a property.  They are simply using a property that they own in a certain way (if they moved into it immediately).  

Love the question.  And really loved taking advantage of the pre 2008 rules.  

 @Dave Foster , 

Thanks for the mention. 

My first concern with this transaction is the qualified use requirement of the property. You can only qualify for the 1031, if you hold the property as investment/ trade or business. If the property is distributed to partners right away to be used as primary residences, the qualified use might be an issue. 

Based on my research, there is currently no clear answer concerning this issue.  And it is recommended the longer the property is held between the date of transfer and the date of exchange the better. The IRS, in Ltr. Rul. 8429039, provided that a two-year holding period is sufficient to ensure treatment as a tax-free exchange (all other tests being met). 

Also, there are cases where the court ruled that the distributed property qualified even after immediately distributing it, if the receiving party still used the property for a trade or investment purpose. Not in this case. 

Thus, If the property is transferred after the 2 year period and/or if 1031 treatment is respected even if distributed before that, we really dont care about when 5 year starts in this case. 

As soon as the property is transferred to partners, the 2-year ownership and use test starts, thus after two years they would qualify for the 121.  Meaning, it really does not make any difference if the 5 years starts on the date of the distribution or date of 1031. 

Also, I think non-qualified use by partnership does not taint the partners.  The Partnership had to own the property for 1031 exchange,  and once it is distributed, the ownership changes, thus the nonqualified use is not transferred to partners. The non-qualified period exists when the owner owns the property and there was non-qualified use.