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1031 Exchange Partnership Issues: Maintaining Tax Deferral for Partnerships and Exiting Partners

1031 Exchange Partnership Breakup and Solutions

Frequently investors pool money and form partnerships or LLCs* to acquire and operate investment properties. Partnerships can defer their taxes utilizing 1031 Exchanges when they sell their properties.

Although partnerships and LLCs are well suited for owning and operating property, they can be problematic when it comes time to sell, especially if the parties want to separate from each other but still want to defer taxes with a 1031 Exchange. At closing, partners who are exiting the partnership cannot take their separate profits and engage in their own 1031 Exchanges. Also, distributing monies to exiting partners at the closing table may negatively impact the partnership’s ability to defer its taxes.

When the entire partnership wants to structure a tax deferred exchange, the transaction can qualify under §1031.  Problems arise, however, when one or more of the individual partners have different investment objectives. Dissolution is sometimes the only solution.


Here are some of the most common partnership dissolution structures:

Distributing an undivided interest

Many practitioners believe there is less risk of an exchange being disallowed on audit if the partners wanting to receive cash on the sale of the Relinquished Property (“cash-out partners”) receive a distribution of their partnership interest. The distribution is in the form of an undivided interest in the Relinquished Property prior to the closing of the sale. As long as there are at least two partners (one of which was in the partnership before the change), the partnership can complete a 1031 Exchange. At the closing, the adjusted partnership and each of the former partners convey their interests in the Relinquished Property to the buyer. The former partners receive their share of the cash sale proceeds, and the Qualified Intermediary receives the portion of proceeds due to the partnership. The partnership is then able to execute a 1031 Exchange. Completing the cash-out arrangement as far in advance of the sale, and if possible, prior to the execution of the contract of sale for the Relinquished Property, is highly desirable.

Liquidate partnership and distribute tenancy-in-common interests

Another possible solution is to liquidate the partnership prior to the exchange and distribute to each partner a tenancy-in-common interest in the Relinquished Property. It is advisable to transfer ownership to the individual Exchangers as far in advance of the exchange as possible, preferably before the property is listed and offered for sale. If a distribution or dissolution occurs shortly prior to the exchange (or shortly after the exchange), an issue arises. That is, was the property sold by (or acquired by) the tenants in common or was it sold by “agents” of the partnership. If it is determined that tenants in common were agents of the partnership, it is likely that the exchange may be challenged by a taxing authority. A valid tenancy in common ownership must be created.

“Drop and Swap” and “Swap and Drop”

Many years ago, these were fairly common techniques used for those partners who wanted to go their separate ways. A “Drop and Swap” transaction occurs when a partnership distributes the Relinquished Property to the partners shortly before the exchange. The “Swap and Drop” transaction occurs when the partnership distributes the Replacement Properties to the partners shortly after the exchange. These transactions are considered aggressive since the partnership’s prior holding period is not attributed to the individual Exchanger (the former partner and current recipient of the property). Accordingly, the exchange may be challenged because the tenants in common were determined to be agents of the partnership. Therefore, the exchange may be disallowed, and the gain will be attributed to the partnership. As a result, “Drop and Swap” and “Swap and Drop” transactions should only be considered with the guidance of a competent tax advisor.

Purchase the interest of a retiring partner

This technique can be implemented before or after a 1031 Exchange. If done before the exchange, the partners who want to exchange contribute additional equity which is used to buy out the retiring partner(s). The partnership then enters into an exchange. Since the partnership sold the Relinquished Property, it must acquire Replacement Property which has the same or greater value compared to the Relinquished Property to fully defer taxes. If the partner buy-out occurs after the exchange, the partnership typically refinances the Replacement Property received in the exchange to generate the cash necessary to buy out the retiring partner(s).

Sale of the Relinquished Property for cash and an installment note

This method involves having the buyer of the Relinquished Property pay with cash and an installment note; the cash is used by the partnership in the exchange and the retiring partner receives the installment note in redemption of his or her partnership interest. If at least one true payment is paid in the following tax year, it should be considered a valid installment note and receive installment sale treatment under I.R.C. §453. Most tax advisors suggest that at least 5% of the total payments of the note be made in the next tax year.

Both above techniques, as well as distributing an undivided interest to a retiring partner, require that after the buy-out or redemption, there must be at least two partners (one of which was in the partnership prior to the ownership change). In cases like these, cooperation techniques work best.


Although the partners may have different investment objectives and want to separate, if they are still willing to cooperate to minimize taxes, there are two other viable options: (1) a partnership division or (2) having the partnership purchase multiple properties. If one partner (or a group of partners) wants to do a 1031 Exchange and the other partner (or group of partners) wants to “cash out” and pay taxes, a partnership division may be an attractive option. However, if all partners want to exchange into separate properties, then having the partnership purchase multiple properties may be a better option.

Partnership division

This technique can be done before, after, and possibly during an exchange. Using the partnership division rules of I.R.C. §708(b)(2), a partnership can divide into two or more partnerships. If a new partnership contains partners, who together, owned more than 50% of the original partnership, it is deemed to be a continuation of the original partnership. Although there may be more than one “continuing partnership”, only the continuing partnership which has the greatest fair market value (net of liabilities) will continue to use the Employer Identification Number (EIN) of the original partnership. All other partnerships resulting from the division will obtain a new EIN.

For example, let’s assume that a partnership is comprised of Billy and Jane (each owns a 50% interest) who no longer want to be partners; Billy wants to do a 1031 Exchange, but Jane wants to sell her interest and “cash out”. Billy-Jane Partnership would divide into two partnerships; Billy-Jane Partnership I (Billy owns a 99% interest and Jane owns a 1% interest) and Billy-Jane Partnership II (Billy owns a 1% interest and Jane owns a 99% interest). Billy-Jane Partnership would transfer the partnership property 51% to Billy-Jane Partnership I and 49% to Billy-Jane Partnership II, as tenants in common. Upon the sale of the Relinquished Property, 51% of the sale proceeds would go to a Qualified Intermediary for Billy Jane Partnership I’s 1031 Exchange and 49% of the proceeds would be distributed to the Billy-Jane Partnership II for further distribution to the individual partners. As a result, Billy has a 99% interest in the partnership which owns the Replacement Property (and which continues to use the original partnership’s EIN) and Jane has received 99% of the cash value of his interest in the original partnership. After one to two years, Billy could buy Jane’s interest in Billy-Jane Partnership I and complete the separation, provided their tax advisor was comfortable with that timing.

Purchase of multiple properties by partnership

Although some authority exists to apply partnership division to situations where both partners want to exchange (but into separate properties); some advisors are not comfortable having their clients do so because only one of the resulting partnerships is permitted to continue to use the original partnership’s EIN. They prefer that the partnership purchase multiple Replacement Properties. Applying this to our example, Billy-Jane Partnership would exchange into two Replacement Properties and amend the partnership agreement to disproportionately allocate the respective income and depreciation from the properties to Billy and Jane. Most advisors believe that at least 10% must be allocated to the minority partner. Then the Billy-Jane Partnership would buy Whiteacre and Blackacre. Billy would be allocated 90% of the income and depreciation of Whiteacre and Jane would be allocated 10%. The reverse would be applied to the allocation of income and depreciation for Blackacre. After a period of time determined by their tax advisor (and with no prearranged plan) Billy and Jane could dissolve the partnership distributing Whiteacre to Billy and Blackacre to Jane.

NOTE: It is our understanding that the California Franchise Tax Board will challenge (in an audit) this type of disproportionate allocation between the partners. Accordingly, Taxpayers should receive the advice and assistance from tax professionals familiar with federal and state issues relating to all of the structures.

For §1031 purposes, most partnership issues can be resolved with advanced planning. Discuss future plans with a tax advisor well in advance of a planned sale. Advance planning can significantly reduce problems and audit risks that you and your partners may face in the future and can help ensure a smooth 1031 transaction.

*Since multi-member LLCs are generally considered partnerships for federal tax purposes, any subsequent reference to a partnership in this article will also apply to a multi-member LLC that has not filed an election to be taxed as a corporation.

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Partnership Issues
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LLC Issues

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