Tax Consequences on Partition and Sale of Land

Overview

Partition and sale of land is a legal remedy available if co-owners of land cannot agree on whether to buy out one or more of the co-owners or sell the property and split the proceeds.  It is often the result of a poorly planned farm or ranch estate where the last of the parents to die leaves the farm or ranch land equally to all of the kids and not all of them want to farm or they simply can’t get along.  Because they each own an undivided interest in the entire property, they each have the right of partition and sell to parcel out their interest.  But, that rarely is the result because they aren’t able to establish that the tract can be split exactly equally between them in terms of soil type and slope, productivity, timber, road access, water, etc.  So, a court will order the entire property sold and the proceeds of sale split equally. 

The court-ordered sale is most likely an unhappy result, and it can be avoided with appropriate planning in advance.  But, what tax consequences result from a partition and resulting sale?  That’s the focus of today’s post.

Basics

A partition of property involving related parties comes within the exception to the “related party” rule under the like-kind exchange provision. This occurs in situations where the IRS is satisfied that avoidance of federal income tax is not a principal purpose of the transaction. Therefore, transactions involving an exchange of undivided interests in different properties that result in each taxpayer holding either the entire interest in a single property or a larger undivided interest in any of the properties come within the exception to the related party rule. But, as noted, this is only true when avoidance of federal income tax is not a principal purpose of the transaction.

As for the income tax consequences on the sale of property in a partition proceeding to one of two co-owners, such a sale does not trigger gain for the purchasing co-owner as to that co-owner’s interest in the property.

Is a Partition an Exchange?

If the transaction is not an “exchange,” it does not need to be reported to the IRS, and the related party rules are not involved.  If the property that is “exchanged” is dissimilar, then the matter is different.  Gain or loss is realized (and recognized) from the conversion of property into cash, or from the exchange of property for other property differing materially either in kind or extent. Treas. Reg. §1.1001-1(a). In the partition setting, that would mean that items of significance include whether debt is involved, whether the tracts are contiguous, and the extent to which they differ.

IRS ruling.  In 1954, the IRS ruled that the conversion of a joint tenancy in capital stock of a corporation into tenancy in common ownership (to eliminate the survivorship feature) was a non-taxable transaction for federal income tax purposes.  Rev. Rul. 56-437, 1956-2 C.B. 301.  Arguably, however, the ruling addressed a transaction distinguishable from a partition of property insomuch as the taxpayers in the ruling owned an undivided interest in the stock before conversion to tenancy in common and owned the same undivided interest after conversion. 

Partition as a Severance

A partition transaction, by parties of jointly owned property, is not a sale or exchange or other disposition.  It is merely a severance of joint ownership. For example, assume that three brothers each hold an undivided interest as tenants-in-common in three separate tracts of land.  None of the tracts are subject to mortgages.  They agree to partition the ownership interests, with each brother exchanging his undivided interest in the three separate parcels for a 100 percent ownership of one parcel. None of them assume any liabilities of any of the others or receive money or other property as a result of the exchange. Each continues to hold the single parcel for business or investment purposes. As a result, any gain or loss realized on the partition is not recognized and is, therefore, not includible in gross income.  Rev. Rul. 73-476, 1973-2 C.B. 301.  However, in a subsequent letter ruling issued almost 20 years later, the IRS stated that the 1973 Revenue Ruling on this set of facts held that gain or loss is “realized” on a partition. It did not address explicitly the question of whether the gain or loss was “recognized” although the conclusion was that the gain was not reportable as income.  Priv. Ltr. Rul. 200303023 (Oct. 1, 2002).

To change the facts a bit, assume that two unrelated widows each own an undivided one-half interest in two separate tracts of farmland. They transfer their interests such that each of them now becomes the sole owner of a separate parcel.  Widow A’s tract is subject to a mortgage and she receives a promissory note from Widow B of one-half the amount of the outstanding mortgage.  Based on these facts, it appears that Widow A must recognize gain to the extent of the FMV of the note she received in the transaction because the note is considered unlike property.  Rev. Rul. 79-44, 1979-2 C.B. 265.

Based on the rulings, while they are not entirely consistent, gain or loss on a partition is not recognized (although it may be realized) unless a debt security is received, or property is received that differs materially in kind or extent from the partitioned property. The key issue in partition actions then is a factual one. Does the property received in the partition differ “materially in kind or extent” from the partitioned property or is debt involved?

It may also be important whether the partition involves a single contiguous tract of land or multiple contiguous tracts of land. However, in two other private rulings, the taxpayer owned a one-third interest in a single parcel of property with two siblings as tenants-in-common.  Priv. Ltr. Ruls. 200411022 (Dec. 10, 2003) and 200411023 (Dec. 10, 2003).  The parties agreed to partition the property into three separate, equal-valued parcels with each person owning one parcel in fee. The property was not subject to any indebtedness. The IRS ruled that the partition of common interests in a single property into fee interests in separate portions of the property did not cause realization of taxable gain or deductible loss.  Rev. Rul. 56-437, 1956-2 C.B. 507.

So, is there any difference taxwise between a partition with undivided interests that are transformed into the same degree of ownership in a different parcel and an ordinary partition of jointly owned property? Apparently, the IRS doesn’t think so.  In one IRS ruling, the taxpayers proposed to divide real property into two parcels by partition, and the IRS ruled that gain or loss would not be recognized. Ltr. Rul. 9327069, February 12, 1993.  Likewise, in another ruling, a partition of contiguous properties was not considered to be a sale or exchange.  Ltr. Rul. 9633028 (May 20, 1996). The tracts were treated as one parcel.

Conclusion

The partition of the ownership interests of co-owners holding undivided interests in real estate is often an unfortunate aspect of poor planning in farm and ranch estates.  That problem can be solved with appropriate planning.  The tax consequences of a partition don’t appear to present a problem if the partition amounts to simply a rearrangement of ownership interests among the co-owners.