A Partnership is a contract between two or more people in a joint business venture who agree to pool their funds and/or talents and share in the profits and losses. General partners are those who are responsible for the day-to-day management of activities. Limited Liability partners are those who contribute only money and are not involved in management decisions. Partnerships are formed for the purpose of economic prosperity, you might say.  However, when that purpose comes to an end, and the partnership dissolves, important decisions must be made.  With proper tax planning and attention to timing you can solve almost any partnership issue that may arise, even when in a §1031 Exchange.


Partners who want to separate their partnership interest in real or personal property face one of the most difficult issues in an exchange.  There are no Treasury guidelines for a conservative approach.  A breakup of the partnership could trigger the taxable gain the partners are trying to avoid.  However, there are various options which deserve consideration pending approval of the partner’s appropriate counsel.  Six of the more common methods are discussed below.  All concepts stated apply equally to members of limited liability companies.

1) THE IRC  §761(a) ELECTION

An IRC §761(a) election allows a partnership to avoid being categorized as a partnership. To qualify, the partnership should be characterized as follows:

  • The group has chosen to be treated as a partnership pursuant to their states partnership laws.  Filing prior partnership returns is preferable.
  • The group has limited involvement in the operation of the property.  Raw land is the most classic example.
  • Limited, if any, restrictions should exist on the rights of co-owners to individually sell their interests.  There should not be any provision in the partnership agreement requiring a vote of a majority to transfer the asset.
  • Each owner should have been allocated a constant pro rata share of income and loss based on their share of ownership.



If possible, an attempt to qualify for an IRC §761(a) election is the first step a partnership should consider when trying to structure an exchange of this nature.  There is probably no restriction against amending an existing partnership agreement to meet the above criteria, assuming the partnership can do so without affecting its operation.  A partnership can make an “affirmative election” through a filing with the IRS no later than the tax filing deadline for the partnership in the year the partnership desires to obtain the election benefits.  

In rare instances, a partnership that does not have a valid IRC §761(a) election in force may still be eligible for a “deemed election.”  The deemed election is available “if it can be shown from all the surrounding facts and circumstances that it was the intention of the members of such organization at the time of its formation to secure exclusion from all Subchapter K beginning with the first taxable year of the organization.”  Subchapter K is the section of the Tax Code encompassing partnership rules.  Exclusion from its application would allow the members to exchange properties as individuals.



Many partnerships will find it hard to meet these strict requirements.  As mentioned previously, the partners could try and amend their partnership agreement to comply with IRC §761(a).  If this tactic is selected, the partnership should operate the property under the new agreement for a period of time before exchanging the Relinquished Property.With the ambiguity that exists when attempting to structure an exchange coupled with a change in the form of ownership, there is no perfect solution short of tax planning far into the future.  If a partnership cannot qualify for the IRC §761(a) election, there are alternate methods to structure an exchange where some partners “cash out” while others exchange their interest for like-kind replacement property. 



This procedure requires the partnership to terminate under IRC §708(b)(1)(A) through a distribution of its assets pursuant to IRC §731(a)(1) and transfer of the exchange property to the partners.  This usually works best when there is just the single property asset in the partnership to avoid the recognition of gain on other low basis assets under IRC §704(c)(1)(B) .  The partners should then own and operate the property as tenants in common for a period of time.


• The partners should cease all partnership activity and each former partner should file their taxes separately, taking a prorated share of income and depreciation.  Since the tax code does not specify how long the property should be held individually, a minimum of one year is suggested with the caveat, “the longer the better.” 

• Once the tenant-in-common owners have held the property for an extended period, they can then each exchange their separate undivided interest into separate replacement properties.  See Miles H. Mason, TC Memo 1988-273.



The potential problem with the IRS is that the Service could successfully argue that the property was distributed primarily for the purpose of facilitating the exchange.  This risk should be minimal provided the property is held by the individual owners for a sufficient period of time


• The decisions in Commissioner v. Court Holding Co., 324 US 331 (1945) and United States v. Cumberland Pub. Serv. Co., 338 US 451 (1950) are helpful when attempting to amend a partnership agreement with a subsequent distribution of the property to the partners as individuals.  The purpose is to avoid having the property viewed as being disposed of by the partnership .

Delwin G. Chase, 92 TC 874 (1989) is an excellent example of what not to do when undertaking this type of exchange.




This technique involves having the partnership amend its partnership agreement in order to allocate gain to the partners wishing to cash out as stated in IRC §704(a).  The Qualified Intermediary then sells the property and purchases a replacement property with a portion of the exchange proceeds.  The remaining proceeds are distributed to the withdrawing partners in complete liquidation of their interests.   



A variation to the Allocation Technique is to have the partnership distribute an undivided interest in the property to those partners wishing to withdraw and cash out.  After the partnership and the withdrawing partners own and operate the property for a period of time as tenants in common, the property could then be sold and the partnership exchange its interest.


• Care must be taken to avoid having the partnership and its new co-owners appear to still be operating as a partnership.  A period of separate ownership operation is desirable.

• Once a buyer is found, the partnership, together with the tenant-in-common owners, enter into a purchase and sale agreement.  Then, they exchange and sell their respective interests.


with the Allocation Technique and the Partial Distribution

• The uncertainty with the tax planning solutions offered in Methods 2 and 3 above is whether the allocations made within the partnership agreement comply with the substantial economic effect necessity of IRC §704(b)(2) and Treasury Regulations §1.704-1(b)(2)(iii)(a).

• The IRS might argue the allocation of gain to the retiring partners lacks substantial economic substance because they receive the same cash value for their shares regardless of the modified allocation at the partnership level.  If the transaction is viewed as a whole, the IRS’ argument might be persuasive. 

• The partnership must be careful not to terminate by selling 50% or more of its total interest in capital or profits pursuant to IRC §708(b)(1)(B).



This approach involves a sale of partnership interests by the partners wishing to withdraw to parties interested in joining as new partners.  The partnership would then make an IRC §754 election to increase the partnership’s basis in the property to be sold.


Again, the partnership must be careful not to sell 50% or more of the total interest in its capital or profits to avoid termination of the partnership under the rules of IRC §708(b)(1)(B).


Sometimes, none of the partners want to retire from the partnership, but simply prefer to own different assets due to separate goals and motivations.  A method to accomplish this requires the partnership to:  1) exchange its Relinquished Property;  2) identify multiple replacement properties; and  3) ultimately acquire those properties. 

The partnership agreement is then amended to provide for allocation of income and deductions to the partner or partners interested in the benefits of a particular property within the partnership’s new portfolio.  Upon the passing of time, the partnership would then be able to distribute the properties to each designated partner.


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