IRS 1031 Exchanges and a Partial Partnership Interest

As an individual owner of a property we know the 1031 exchange is an IRS-approved technique to defer gains from one property into another one. This article looks at issues surrounding IRS 1031 exchanges and a partial partnership interest.

As a general concept, when relinquished property is owned by a partnership, the process of exchanging that property for another like-kind replacement property becomes a bit more complicated. Here are a few reasons why:

A partnership, much like a corporation, is an entity unto itself that assumes all characteristics of an individual and is regarded by governments and other institutions as an individual. While many people may have partial interest ownership of the partnership, they, as individuals, are not responsible or liable—the partnership is.

If one owner within the partnership wants to conduct a 1031 exchange, he or she cannot. The IRS will not allow a co-owner to exchange partnership interest for real estate. The partnership only, as an entity, can dispose of the relinquished property and the partnership, as an entity, can acquire the replacement property. In other words, the relinquished piece of real estate is exchanged for the replacement real estate by the partnership – not the individual partners in the partnership.

So what is an individual partner of a partnership to do in order to complete a 1031 exchange? A start would be to try to convince other partners to also complete a 1031 exchange on behalf of the partnership. If that doesn't work and not all partners agree to the exchange, an individual partner could suggest to be bought out of the partnership. That then relieves an individual partner of any responsibility to the partnership. However, there is a good chance the exiting partner would have to pay taxes on his partnership gain.

If those two options above are unsuccessful, the various partners could consider dissolving the existing partnership arrangement and petitioning for Tenancy-in-Common treatment of the underlying real estate assets. This would restructure the ownership of the property and allow each of the partners to participate in his or her own investment strategies without impacting the other partners. However, there are strict regulations set forth by the IRS to determine what constitutes ownership in such an arrangement. It may take a year or so before restructured real estate ownership is acknowledged as eligible for 1031 treatment.

While a 1031 exchange involving partial partnership is possible, there are many issues that arise. Prudent, careful, and advanced planning are the keys to avoid a messy exchange.