Partnership Considerations When Structuring 1031 Exchanges
Partnerships were a common vehicle for real estate investment in the 1960s, 1970s, and 1980s, especially when multiple investors wanted to pool funds for large-scale projects. They offered liability protection for individual partners and allowed income to pass through to each partner’s personal tax return.
While effective for ownership, partnerships can create significant complications when investors want to take advantage of a 1031 Exchange. Understanding how partnership structures interact with IRS rules is essential to avoid pitfalls.
Partnership Interests and 1031 Exchanges
Under Section 1031 of the Internal Revenue Code, partnership interests are specifically excluded from like-kind exchange treatment. This is because:
A partnership interest is considered personal property, not real property.
Only direct ownership of real estate (fee title) qualifies for a 1031 Exchange.
Even if the partnership itself owns real estate, an individual partner cannot exchange their interest in the partnership for real property and achieve tax deferral.
This creates a challenge for partners who wish to separate and pursue different investment goals after a property sale.
The Core Issue
The critical distinction is that the partnership owns the real estate, while individual partners own interests in the partnership. When the partnership sells a property, the partners typically receive a cash distribution. Cash and partnership interests do not qualify as like-kind property under 1031 rules, which makes planning ahead essential.
Structuring Challenges
A 1031 Exchange is possible when completed at the partnership level. However, complications arise when:
Some partners want to cash out and pay taxes, while
Others want to exchange into new property to defer taxes.
These conflicting goals require careful structuring and advanced tax planning to avoid disqualification of the exchange.
Potential Structural Solutions
Although partnership interests themselves cannot be exchanged, there are several strategies investors and advisors may consider to achieve deferral:
Dissolve the Partnership (IRC §708)
Partners sell their interests, dissolve the partnership, and pay taxes.
Straightforward, but no tax deferral is achieved.
Buyouts Within the Partnership
Some partners or new investors purchase the interests of partners wishing to exit.
The partnership then completes a 1031 Exchange at the entity level.
1031 Exchange Followed by Refinance
The partnership completes a 1031 Exchange into replacement property.
After a suitable holding period, the property is refinanced, and cash is distributed to exiting partners.
Swap and Drop Strategy
The partnership completes a 1031 Exchange.
After holding the property (generally 24+ months to demonstrate investment intent), the partnership reorganizes into tenants-in-common (TIC) ownership.
Each owner then controls a direct fractional interest and can later pursue their own exchange.
Drop and Swap Strategy
The partnership reorganizes into TIC ownership before a sale.
Each owner then independently completes a 1031 Exchange or cashes out, depending on their goals.
Section 761(a) Election
In some cases, partnerships can elect out of Subchapter K, treating investors as holding direct interests in assets rather than in the partnership.
This option is limited and generally applies to investor groups not formally organized as partnerships filing IRS Form 1065.
Key Considerations
Timing is critical—these strategies often require advance planning well before a sale.
IRS scrutiny has increased, so demonstrating investment intent and adhering to holding periods is essential.
Each partner’s goals, as well as partnership agreements, need to be carefully reviewed with legal and tax advisors.
