Can a Partnership Do a 1031 Exchange?

Yes, a partnership or LLC can perform a 1031 exchange. Under IRS rules, any taxpayer, investor, or corporation can successfully defer taxes through a 1031 exchange transaction; however, the process requires strict compliance with IRS regulations, timelines and partnership agreements. 

For a partnership, it can even be more challenging because of its complex real estate ownership structure and common misconceptions surrounding how it works. Having a Qualified Intermediary (QI) guide you through the process can help ensure that the exchange runs smoothly and stays valid.

Universal Pacific 1031 Exchange stands out as one of the best Qualified Intermediaries in Los Angeles and beyond. We specialize in managing 1031 exchanges from start to finish, helping clients navigate IRS rules, and providing expert financial guidance to ensure a seamless transaction. Take the first step towards a smooth, compliant exchange by scheduling a free consultation today. 

In this article, we explore the distinction between a partnership and partner interests, discuss the possibility of a partnership conducting a 1031 exchange, and delve into strategies for partnerships to successfully carry out a 1031 exchange.

What Is a 1031 Exchange?

A 1031 exchange is a tax-deferral strategy that allows a taxpayer to sell an investment or business property and use the proceeds to acquire a replacement property without immediately paying capital gains taxes. 

This type of like-kind exchange applies to nearly all forms of real properties, so long as the properties under consideration meet the IRS’s qualified use and holding requirement rules. This means that both properties must be held for investment or business use to be eligible for a like-kind exchange. 

To successfully carry out a 1031 exchange, the taxpayer must adhere to the IRS’s strict rules and timelines. This involves identifying the new property within 45 days after selling the old one and finishing the purchase within 180 days. Also, a qualified intermediary is required to facilitate the exchange and hold the sale proceeds. 

Can a Partnership Do a 1031 Exchange?

Yes, a partnership can carry out a 1031 exchange, but only with proper restructuring and careful planning. The IRS allows the exchange of real property owned by a partnership for other like-kind property as long as the property is held for investment or business use. 

What the IRS does not allow is the exchange of partnership interests themselves because an ownership share in a partnership is not the same as owning real estate. This is where many people get confused; the partnership owns the relinquished property, not the individual partners. 

If the property is sold, the whole partnership entity can buy replacement property in a 1031 exchange, but the partners cannot simply trade their real property interests in the partnership and expect to defer taxes. If some partners want cash while others want to reinvest, the partnership must be restructured first.

Partnership vs. Partner Interests in a 1031 Exchange

In a 1031 exchange, there is a big difference between exchanging real estate and exchanging partnership interests. When a partnership owns real property for investment or business use, the partnership itself can sell that property and buy replacement property in a valid 1031 exchange. Because the property is like-kind to other real estate, it qualifies under IRS rules.

However, the IRS does not treat partnership interests the same way as real property. An ownership share in the partnership entity is considered personal property. Selling or swapping that interest is treated like selling stock in a company, rather than selling land or buildings. As a result, exchanging a partnership interest does not qualify for tax deferral under Section 1031.

This is why real estate owned by the partnership can be part of a 1031 exchange, but the partnership interests cannot. If individual partners want to go their separate ways and defer taxes, the ownership often needs to be restructured first.

Strategies for Partnerships to Complete a 1031 Exchange

Partnerships intending to use a 1031 exchange to defer taxes often face a major challenge when partners are not in agreement. Because the IRS does not allow the exchange of partnership interests, the ownership structure usually needs to be restructured so each partner can make their own decision about taxes and investments. There are a few common strategies partnerships can use to complete a 1031 exchange.

One common approach is the drop-and-swap method. Here, the partnership first transfers the real property to the individual partners as tenants in common (TIC), meaning each partner owns a direct share of the property. After this “drop,” the property is sold, and each partner can decide whether to take cash and pay taxes or complete their own 1031 exchange into new investment property. 

One major risk this method faces is meeting IRS timing rules. The IRS requires that the property must have been held for a period of time to establish investment intent, so transferring right before the sale can trigger unexpected tax liabilities.

Another strategy is the swap-and-drop method, where the partnership sells the old property and acquires the replacement property at the partnership level. After the exchange is completed, the ownership is then divided among the individual partners. This avoids the timing issues at the beginning, but still, the IRS requires that each partner hold onto their shares for a period of time after the drop to meet the holding period requirements for a 1031 exchange.

Some partnerships also opt for a partnership division or restructuring. In this case, the partnership is dissolved before the sale, and the real estate property is split into tenants-in-common ownership or separate entities. Separate entities mean that those who want to see the 1031 exchange through can remain in the partnership, while the exiting members will probably group into a new partnership where they can get immediate cash from the sale.

This approach gives each partner more control. But just like the other two methods, the property must be held long enough to show investment intent.

Other strategies include: 

• A partnership buyout before the exchange allows partners intending to cash out to sell their individual interests to the remaining partners before the exchange.
• Refinancing after the exchange is another option. Here, the partnership completes the 1031 exchange first. After acquiring the replacement property, the partnership refinances and uses the loan proceeds to pay cash to the redeemed partners who wanted to cash out. This avoids the problem of distributing money before the exchange, which would be taxable.
• Section 761(a) election allows partners to opt out of partnership tax treatment so they are treated as if they directly own the property. This case is rare and only available if the partnership is organized purely for investment purposes and meets strict IRS criteria.
• Another option is using Delaware Statutory Trusts (DST) instead of holding property directly. This approach makes it easier to exchange interests and meet like-kind requirements while providing professional property management.

Risks and IRS Compliance Concerns

Even when partnerships use strategies like drop-and-swap or swap-and-drop, there are risks if the IRS believes the steps were taken solely to avoid taxes. This is known as the step transaction doctrine. If the IRS believes the transfer of property to individual partners and the sale occurred at the same time or too close together, it might treat everything as one transaction and deny the 1031 exchange benefits.

Another concern is the holding period requirement. As previously mentioned, the IRS expects a property to be held for real investment purposes, and not just to be sold immediately. Many tax experts recommend holding the property for at least a year or even up to two years before selling or dividing it. In the same vein, the property should be held for the same period immediately after the partnership has been restructured. This helps prove the intent to use the property as an investment, which is critical for a valid like-kind exchange.

Because the rules can be complex and mistakes can easily lead to the loss of tax benefits, it is essential to work with experienced tax advisors, attorneys, and a Qualified Intermediary (QI). They help ensure that the timing, paperwork, and structure meet IRS rules so the exchange stays safe from future problems.

What Happens If Partners Disagree on a 1031 Exchange?

As mentioned earlier, one major issue with a partnership is the clash of interests that may arise between individual partners on whether to carry out a 1031 exchange or simply take cash and pay taxes on it right away. This creates a significant problem because an exchange is only valid if the same taxpayer who sells the property also buys the replacement property. 

Any cash distributed to exiting partners is considered boot and becomes immediately taxable. When this arises, the partnership can utilize any of the strategies discussed above, which include using methods like drop-and-swap, swap-and-drop, or splitting into tenants-in-common so co-owners hold a direct share of the property before sale. 

Then the partners who want to exchange can do so on their own, while the former partners simply take their cash. Another option is selling the property and splitting the money; however, in this case, no one gets the tax benefits of a 1031 exchange. 

Please note that each choice has legal and tax implications, so it is important to work with experienced tax advisors and attorneys to ensure fewer delays and errors. They can help plan the exchange properly so it stays valid in the eyes of the IRS for those who want to invest, while avoiding unexpected tax bills for everyone else.

When Should a Partnership Consider Alternatives?

A partnership should consider other alternatives if a 1031 exchange does not fit their situation. This often happens when the partners have conflicting interests, when the holding period and timeline rules cannot be met, or when the step transaction doctrine risk is too high. In these situations, several alternatives may provide tax or investment benefits even if they do not fully replicate the tax deferral of a 1031 exchange. 

For example, an installment sale allows the buyer to receive payments over time, spreading out the capital gains tax instead of paying it all at once. Investing in Opportunity Zones can offer tax incentives for reinvesting gains into qualifying projects in designated areas, potentially reducing or deferring taxes depending on the structure. 

Another option is a Delaware Statutory Trust (DST), which allows investors to pool funds into professionally managed real estate projects. DSTs can often qualify for 1031 exchange treatment and provide passive income without requiring direct property management. 

Role of a Qualified Intermediary in Partnership Exchanges

A Qualified Intermediary (QI) plays a critical role in ensuring that partnership 1031 exchanges meet all IRS requirements. Notably, a QI holds sale proceeds from the relinquished property. This is because the IRS rules require that the proceeds from the sale of the relinquished property never pass through the hands of the taxpayer or the partnership.

As such, the QI is responsible for receiving and holding these funds in an escrow account, and using them to acquire the replacement property when the time comes. This helps prevent what is called a constructive receipt, which could disqualify the exchange. The presence of a QI is nonnegotiable for an exchange to be considered valid, and this becomes even more important when dealing with partnership exchanges. 

This is due to its complex ownership structure, and the involvement of a qualified intermediary in the transaction helps to avoid taxable consequences. In addition to holding funds, the QI also helps to ensure that all IRS deadlines are met, paperwork is accurate, and the exchange remains compliant.

Need Help With Your 1031 Exchange as a Partnership?

Carrying out a successful 1031 exchange within a partnership demands meticulous planning. The strict ownership structure, timing requirements, and potential for disagreements among partners can make a partnership 1031 exchange a complex endeavor.

Working with experienced tax advisors, attorneys, and a trusted Qualified Intermediary (QI) ensures that your exchange is structured correctly, deadlines are met, and the transaction remains fully compliant with IRS regulations.

Universal Pacific 1031 Exchange has years of experience in handling even the most complex like-kind exchanges. We offer expert guidance for investors and corporations alike on how to successfully carry out a 1031 exchange without any hassles. To get started, you can visit any of our offices to start an exchange today.

FAQs on Partnership 1031 Exchanges

Here are some common questions about 1031 exchanges for partnerships.

How Can a Partnership Participate in a 1031 Exchange?

A partnership can complete a 1031 exchange if it sells real estate and acquires replacement property in its name. However, suppose individual partners want to go their separate ways. In that case, the ownership structure may need to be changed first. This can be done using methods such as a drop-and-swap transaction or tenancy-in-common (TIC), so each partner can control their own exchange or take cash.

How Do I Report a 1031 Exchange on a Partnership Return?

The exchange is reported in the same tax year the property was sold using IRS Form 1065, the partnership tax return. The transaction details are included on the partnership’s books, and each partner’s share of income, gains, or losses flows through to their personal tax return via Schedule K-1. A Qualified Intermediary (QI) and tax advisor usually prepare the correct documents to meet IRS requirements.

Can an LLC Partnership Do a 1031 Exchange?

Yes, as long as the limited liability company (LLC) is taxed as a partnership or as a disregarded entity (like a single-member LLC). The key is that the entity selling the property must also buy the replacement property to meet the IRS’s same taxpayer rule.

What Is the Main Reason Partnerships Cannot Directly Exchange Partnership Interests in a 1031 Exchange?

The IRS considers partnership interests to be personal property, not real property. Since Section 1031 applies only to real estate, exchanging a partnership interest itself does not qualify for tax deferral, even if the partnership owns real estate.

Can a Partnership Interest Itself Be Exchanged?

No. A partnership interest cannot be exchanged for other property under Section 1031. Only the real estate owned by the partnership can qualify, not the individual ownership interests in the partnership.

What Happens if Only Some Partners Want to Exchange?

The partnership may restructure so that partners wanting to cash out receive cash, while those wanting to defer taxes get direct ownership of the real estate before the sale and complete their own exchange. This requires careful planning and compliance with IRS timing rules.

How Long Must Property Be Held Before Exchanging?

The IRS has no fixed rule, but tax professionals generally recommend holding property for at least one to two years to show a clear intent to hold it for investment purposes before doing a 1031 exchange. This helps meet the IRS’s qualified use requirement and reduces audit risks.