A partnership may exchange business personal property with any other entity in a transaction qualifying under IRC §1031, as long as the partnership meets the requirements that apply to all exchange transaction (i.e. both the relinquished and replacement properties will be held for investment or business purposes).

A key issue when addressing exchanges involving partnerships is to first determine the investment objectives of the individual partners in the partnership. When the entire partnership wants to structure a tax deferred exchange, it is clear that the transaction can qualify under §1031. Problems arise, however, when one or more of the individual partners have different investment objectives.

The most commonly asked question is "Can a valid §1031 exchange still be structured if one of the partners drops out of the partnership?" Often one or more of the partners desire to withdraw from the partnership and receive cash or other property in return for their partnership interest.

Since an interest in a partnership is personal property, possible solutions are to liquidate the partnership either prior to or after the exchange so that each "partner" will receive an interest as a tenant-in-common in the real property with the other former partners.

For example, for a relinquished property owned by a partnership, if either the entire partnership or one or more of the partners receive a direct interest in the underlying assets of a liquidated partnership interest, the key issue is whether the relinquished property was "held for productive use in a trade or business or for investment purposes." This "qualified use" requirement must be met for any exchange. The Tax Court seems to utilize the substance-over-form doctrine in situations like these.

In "Bolker v. Commissioner," 81 TC 782 (1983), aff'd 760 F2d 1039 (CA9 1985), the individual taxpayer entered into an exchange agreement for his relinquished property on the same day that he received a liquidating distribution of the property from his wholly-owned corporation. He then acquired a replacement property three months later to complete his exchange. The Tax Court held that the qualified use requirement is met as long as the taxpayer does not intend to liquidate the relinquished property or use it for personal pursuits.

In "Maloney v. Commissioner," 93 TC 89 (1989), a corporation exchanged real property and, at the time of the exchange, had the specific intent to liquidate and distribute the replacement property to its shareholders. One month after completing the exchange, the corporation liquidated under the former IRC §333, distributing the replacement property to its shareholders. The Court held that even though there was a change in ownership, the continuity of investment satisfied the qualified use requirement and upheld the validity of the §1031 exchange.

Although "Bolker and Maloney" both involve corporations, the argument that the taxpayer is merely continuing its investment in another form is more convincing in the partnership context given the aggregate nature of a partnership

As a result, if properly structured, it appears that a valid §1031 exchange can occur as long as the taxpayer does not "cash-out" their investment. However, a prudent taxpayer must plan carefully. Failing to properly liquidate a partnership interest prior to an exchange can lead to a taxable event. See "Chase v. Commissioner," 92 T.C. 53 (1989).

Transactions of this type can be complicated and should be carefully reviewed by qualified tax and legal counsel to determine whether the facts and circumstances are strong enough to support a defensible tax deferred exchange.