Like-Kind Exchanges of Partnership Properties

By Michael M. Smith, J.D., CPA; Donald L. Ariail, D.B.A., CPA


  • A partnership can distribute real property to its partners so that the partners can exchange the property in a Sec. 1031 like-kind exchange; if the exchange is properly structured, some of the partners can trade their interests in the property distributed in Sec. 1031 exchanges and some of the partners can sell their interests in the property in taxable transactions.
  • When challenging the validity of a Sec. 1031 exchange of property distributed by a partnership, the IRS will likely use one or more of three theories: (1) the partners did not hold the property for a qualified use, (2) the steptransaction doctrine, and (3) the partners' cotenancy in the property is a partnership.
  • As an alternative to distributing the property before the exchange, a partnership could exchange the property for cash and installment notes, buy replacement property with the cash, and distribute the installment notes to partners who wish to withdraw from the partnership.

Owners of real estate often use Sec. 1031 to make tax-deferred exchanges of underperforming properties for newer replacement properties. However, when the real estate is held in a partnership or a limited liability company (LLC) having multiple owners (that is treated as a partnership for tax purposes), the exchange can become complicated if one or more of the partners (or members) wants to withdraw from the partnership or LLC without participating in the exchange transaction.

A withdrawing partner cannot simply take cash for a beneficial interest in a real estate transaction without affecting tax treatment to the remaining partners. Moreover, exchanges of partnership interests expressly do not qualify for taxfree treatment under Sec. 1031(a)(2)(D). Accordingly, for a partnership to receive tax-free treatment, the exchange must occur at the partnership level or the partners desiring individual tax-free treatment must receive a real estate interest from the partnership that they can exchange individually or along with the interests of the other partners who desire tax-free treatment. This article summarizes various potential alternatives—and their related tax risks—that are available when considering an exchange involving real estate owned by a partnership or an LLC treated as a partnership for tax purposes.

Exchange After Distribution to Partners

One possibility for achieving tax-free treatment at the partner level is for the partnership to distribute its real property to its partners on a pro-rata basis (according to their respective interests in the partnership) and then dissolve.1 A distribution by a partnership will generally be tax free under Sec. 731. The resulting former partner cotenants, holding the real estate as tenants in common, could then collectively enter into an agreement with a third-party purchaser for the sale of the relinquished property while reserving their rights to effect separate exchanges (tax free) or receive cash (taxable) for their respective interests therein. Each such cotenant thereafter desiring exchange treatment could then assign his or her respective interest in the sales contract to a qualified intermediary and close the transaction as an exchange. Those cotenants wanting cash could then treat their respective portion of the disposition as a taxable sale and report the transaction as a taxable event on their income tax returns.

Exchange Prior to Distribution to Partners

Assuming that all partners desire tax-free exchange treatment but want to end up with separate properties and then dissolve the partnership, the partnership itself could exchange on its own the relinquished property and enter into contracts to acquire several replacement properties, each suitable to its respective partners. Following the closings, the partnership could then distribute the separate properties to the respective partners, as the partners may agree, in liquidation of the partnership. 2

Instead, prior to the tax-free transaction, if some of the partners want to continue in the partnership and others want out, the partnership could "cash out" the withdrawing partners in a redemption transaction, or the partners wanting to continue with the partnership could directly purchase the withdrawing partners' partnership interests. Either of these alternatives would result in a tax recognition event for the withdrawing partners. The partnership would then be free to exchange the real property without participation by the withdrawing partners.

Exchange by Partnership

Although a partnership is a conduit entity, the partnership is the taxpayer for purposes of analyzing the validity of any exchange conducted at the partnership level. Accordingly, the partnership must be able to prove that the relinquished property has been, and that the replacement property will be, held for a qualified use, as discussed below.

Deferred Exchange Special Requirements

The partnership, as well as the former partners who may be separately exchanging their real estate interests, must individually meet two basic requirements to achieve separate tax-free exchanges. First, replacement property must be identified by each exchange party in a writing that is delivered to the qualified intermediary or other person involved in the exchange within 45 days following the transfer date of the sale of the relinquished property.3 Replacement property that is acquired within such 45-day period is deemed identified without supplying the notice.4 There are specific rules relating to the number of properties that can be identified and the level of detail required in the identification notice.5

Second, the like-kind replacement property must be acquired within the earlier of

  1. 180 days following the transfer date of the sale of the relinquished property, or
  2. The due date, including extensions, of the property owner's federal income tax return.6
Times for the performance under the 45- day and 180-day rules end at midnight on the 45th day and 180th day, as the case may be, and are calculated without regard to Sec. 7503 (which extends the time for performance when the last day falls on a Saturday, Sunday, or legal holiday).7

There are no extensions of these deadlines.8 The Tax Court has invalidated an exchange because the exchanger failed to meet the 180-day period even though he made a good-faith effort to do so.9

Any real property that will be held for investment or for use in a trade or business generally will qualify as like-kind replacement property for purposes of Sec. 1031(a)(3)). Regs. Sec. 1.1031(a)-1(b) defines "like-kind" to refer to the nature or character of the property and not its grade or quality. Accordingly, in the context of real estate, if a hotel is the relinquished property, the replacement property need not be another hotel but may be another property to be held for use in a trade or business or for investment, such as an apartment building, raw land, or a shopping center.

A leasehold interest may be either real or personal property depending on state law. Real property is not like-kind to personal property. However, the regulations specifically state that leasehold interests in real property having a term of 30 years or more are considered like-kind to fee interests in real property, regardless of state law.10

Tax Risks

The IRS could challenge any of the abovedescribed exchanges that involve a distribution of either relinquished or replacement property to the partners before or after the exchange. The three principal theories that could be used by the Service to challenge tax-free treatment are (1) the partners do not hold the property for a qualified use, (2) the step-transaction doctrine, and (3) the partners' cotenancy in the property is a partnership.
Qualified Use
The IRS could argue that a transaction violates the qualified use requirement because the transaction was prearranged and did not meet the requirement of intent to hold the property for investment or for use in a trade or business.11 In Wagensen,12 the Tax Court held that an exchange followed by a gift of replacement property within nine months after an exchange satisfied the holding requirement. In that case, the exchanger was determined to not have had a definite plan to dispose of the replacement property at the time of the exchange.

In Click,13 on the other hand, the Tax Court held that an exchange failed to qualify under Sec. 1031 where, at the time of the exchange, the taxpayer intended to give away the replacement property to her children. In that case the exchanger's children occupied the replacement properties, which were residences, on the date of the exchange and the residences were transferred by gift to the children approximately seven months after the exchange.

Although existing legal authority is not clear on how long a taxpayer must hold real property for such use, the Service has been unwilling to attribute a partnership's qualified use to a partner who, upon receipt of the distribution, immediately or shortly thereafter transfers it in a tax-free exchange. However, the courts have generally agreed with taxpayers who have taken the position that real estate can be transferred into or out of entities without triggering a new holding period or the termination of a holding period, the theory apparently being that any such transfer changes only the form of the investment and not the use.14

Step-Transaction Doctrine
The IRS could argue that the exchange was part of a series of steps the owners undertook to circumvent Sec. 1031(a)(2)(D), which prohibits exchanges of partnership interests and that the substance of the transaction amounted to an exchange of a real property interest for a partnership interest, or vice versa. 15 In Magneson,16 the exchanger acquired replacement real property and immediately contributed it to a partnership in return for a general partnership interest. The Tax Court found that the transaction qualified under Sec. 1031, noting that the exchanger did not cash out of the investment but merely changed continued ownership of the replacement property from direct to indirect.

Following the amendment to Sec. 1031 in 1984, it is unclear whether the steptransaction doctrine would invalidate Magneson if an exchange followed by a transfer of the replacement were in substance an exchange of real property for a partnership interest. There have been no reported cases on the issue since Magneson.

Alternatively, the IRS could argue that, in substance, the party disposing of the property in the exchange was not the same as the party acquiring the replacement property. 17

Cotenancy Remains a Partnership
The IRS could assert that the transfer of the relinquished property to the partners does not change the economic relationship among the partners. Thus, the IRS and the courts may consider a cotenancy to be a partnership for tax purposes if the business activity of the cotenancy resembles a partnership. For example, a partnership may exist for tax purposes if the cotenancy conducts business or actively manages the property.18 Accordingly, the Service could view the subsequent exchange transaction by one of the tenants as an exchange of a partnership interest for real estate. Therefore, it is important to evaluate the business activities that the co-owners are carrying on.

Often when individuals own property as co-owners, the line between partnership status and co-ownership for income tax purposes can become blurred. Co-owners can avoid partnership status by keeping the management activity of the property at a minimum level—for example, by only maintaining and keeping the property in repair and providing customary lessee services through an agent. The regulations contain some guidance on the level of activities that co-owners can undertake without being construed as a partnership.19 In addition, if certain requirements are met, the cotenants can make an election, commonly called the Sec. 761(a) election, to be excluded from tax treatment as a partnership provided that the cotenancy is for investment purposes and not for the active conduct of a business.20

Productive real properties such as hotel properties are usually considered operating businesses, and multiple owners of tenancy in common will likely be considered partners under the tax law. Accordingly, the cotenancy will need to separate the real estate ownership from the business operations by forming another entity to conduct operations and manage the property. The cotenancy would then lease the real estate to the operating entity and effectuate exchange transactions with the productive real property.

Minimizing IRS Challenge

Taxpayers undertaking an exchange following a distribution by a partnership should try to minimize their risk of a successful IRS challenge. The following suggestions may help:
  • First, the sales contract with a third party should not be signed by the partnership but should be negotiated and entered into by the former partners after the distribution by the partnership has occurred and deeds are recorded.
  • Second, the partners and the partnership should allow for as much time as possible to pass between the dates of the exchange transaction and the distribution from, or contribution to, a partnership. At least one year should pass between the distribution and the initiation of the exchange with a qualified intermediary party and sale to the third-party purchaser. This suggestion is supported by the holdings in Click and Wagensen.
  • Third, if the partnership is no longer conducting business, it should be dissolved in accordance with state law and the partnership agreement.
  • Fourth, all closing documents, books, records, and tax returns should reflect ownership by cotenants and a disposition of the property by the partnership to the cotenant long before any exchange transaction involving the property occurs.
  • Fifth, cotenants should, if possible, also make a Sec. 761(a) election to not be taxed as a partnership, and accounting for the property's operations should be handled in the form customary for a tenants-in-common arrangement. The cotenants should also enter into a written cotenancy agreement that clearly expresses their intention not to be a partnership.

Installment Sale Opportunity

Assuming that some of the partners want to continue the partnership and others want out, the exchange could be structured at the partnership level so that the exchange proceeds consist of both cash and an installment note or notes (at least one payment must be received in a tax year after the year of the sale). Cash could be used by the exchange intermediary to purchase replacement property, and the note or notes could be used to redeem the partnership interest of the withdrawing partner(s). The note or notes could be secured by a standby letter of credit rather than by the property sold. 21

Following the completion of the exchange, but before any note is due, the partnership could distribute the note or notes to the withdrawing partners in redemption of their partnership interest. The partnership would recognize no gain on the redemption transaction (except to the extent of depreciation recapture and unrealized receivables), and the withdrawing partners would take the note with a tax basis equal to their basis in the redeemed partnership interest. 22 When the note is collected, the redeemed partners would then have a taxable gain (and interest income) equal to the excess of the note proceeds over their basis in the note.

Alternatively, a partner wanting to withdraw might be persuaded by the other partners to accept a deferred payment for his or her partnership interest prior to any exchange being undertaken. A deferred payment redemption of a partner provides an additional possible income tax deferral that is not otherwise available under the installment rules. To the extent that payments are made to the partner for his or her interest in the partnership, the redeemed partner does not recognize any gain from the redemption until the partner has received an amount equal to his or her basis in the partnership. 23


Tax-deferred exchanges involving productive real properties can be a viable tax deferral mechanism even when the real estate is held in a partnership. However, documenting the transaction and proper planning and "aging" of the steps involved in meeting the needs of all partners is critical and should not be overlooked. Given the enumerated constraints and proper consideration of both the tax benefits and risks, taxpayers can use exchanges structured with sufficient planning and documentation to defer substantial income tax for an indefinite period.
Editor Notes

Michael Smith is a shareholder in Baker, Donelson, Bearman, Caldwell & Berkowitz, PC, in Atlanta, GA. Donald Ariail is an associate professor in the Department of Business Administration at Southern Polytechnic State University in Marietta, GA. For more information about this article, contact Prof. Ariail at

1 See Mason, T.C. Memo. 1988-273.

2 Sec. 708(b)(1)(A). See Maloney, 93 T.C. 89 (1989), in which the Tax Court approved a like-kind exchange of property before a liquidation in a corporate setting.

3 Sec. 1031(a)(3)(A).

4 Regs. Sec. 1.1031(k)-1(c)(1).

5 See Regs. Secs. 1.1031(k)-1(c)(3) and (4).

6 Sec. 1031(a)(3)(B).

7 Rev. Rul. 83-116, 1983-2 C.B. 264. The IRS ruled that Sec. 7503 applies only to acts required to be performed in connection with the determination, collection, or refund of taxes.

8 Sec. 1031(a)(3).

9 Knight, T.C. Memo. 1998-107.

10 Regs. Sec. 1.1031(a)-1(c).

11 Rev. Rul. 75-292, 1975-2 C.B. 333.

12 Wagensen, 74 T.C. 653 (1980).

13 Click, 78 T.C. 225 (1982).

14 Magneson, 81 T.C. 767 (1983), aff'd, 753 F.2d 1490 (9th Cir. 1985); Maloney, 93 T.C. 89 (1989); Bolker, 81 T.C. 782 (1983), aff'd, 760 F.2d 1039 (9th Cir. 1985).

15 Sec. 1031(a)(2)(D) was added by the Defi cit Reduction Act of 1984, P.L. 98- 369, Section 77(a).

16 Magneson, 81 T.C. 767 (1983), aff'd, 753 F.2d 1490 (9th Cir. 1985).

17 Court Holding Co. , 324 U.S. 331 (1945); Chase, 92 T.C. 874 (1989).

18 Sec. 761(a).

19 Regs. Sec. 1.761-1(a); see also Rev. Proc. 2002-22, 2002-1 C.B. 733.

20 Regs. Sec. 1.761-1(a).

21 Regs. Sec. 15A.453-1(b)(3).

22 Regs. Sec. 1.453-9(c)(2); Sec. 732(b).

23 Sec. 731(a)(1); Regs. Sec. 1.731-1(a)(1)(i).

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