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Internal Revenue Code (IRC)
§1031 and Partnerships

A partnership, which is a taxpayer separate from its partners or members, may exchange real property under §1031, as long as the partnership meets the requirements that apply to all exchange transactions. For example:

• The same taxpayer starts and completes the exchange
• Both the Relinquished and Replacement Properties will be held for investment or business purposes
• Exchanger identifies a replacement property within 45 days of selling the relinquished property

Frequently Asked Questions

Do the individual partners need to have the same investment objectives?

One important issue to consider when addressing exchanges is each partner’s individual investment objectives. If the entire partnership wants to structure a tax-deferred exchange, the transaction can qualify under §1031; however, issues may arise when one or more of the individual partners have different investment objectives.

Can a valid exchange be structured if one of the partners drops out of the partnership?

Often, one or more of the partners choose to withdraw from the partnership and receive cash or other property in return for their partnership interest. Advanced planning can ensure that most partnership issues can be resolved. Partners who may want to separate in future investments or sell their interest in the existing asset for cash should consult with their tax advisors well in advance of the proposed sale before structuring the transaction.

What are the steps for distributing an undivided interest?

The partners wishing to receive cash on the sale of the Relinquished Property receive a distribution of their partnership interest via an undivided interest in the Relinquished Property before the sale closes. So long as there are two partners remaining in the partnership, this leaves the partnership intact, and the partnership can exchange its remaining property. Ideally, the distribution of the tenant in common interest to the former partners should occur before the Purchase and Sale Agreement is signed.

At the closing, the remaining partnership, including former partners, convey their interests in the Relinquished Property, with the former partners receiving cash, and the Qualified Intermediary receives the net proceeds due to the partnership. This enables the partnership to execute the exchange when a new property is identified.

Another solution is to liquidate the partnership prior to the exchange. How would this work?

This involves liquidating the partnership prior to the exchange and distributing (to each partner) a tenancy-in-common interest in the Relinquished Property. It is advisable to transfer ownership to the individual Exchangers as far in advance of the exchange as possible, as much as two years.

If a distribution occurs shortly prior to the exchange, the distribution and the exchange may be disallowed. The key issue is whether the Relinquished Property was “held by the Exchangers for productive use in a trade or business or for investment purposes” for a sufficient period such that the former partners enjoy the “benefits and burdens of ownership”. This qualified use requirement must be met by the individual Exchanger (former partner) for the exchange to be valid. It becomes problematic when the distribution occurs within close proximity of the sale or purchase transaction.

What are “Drop and Swap” and “Swap and Drop” transactions?

“Drop and Swap” transactions are when a partnership distributes the Relinquished Property to the partners shortly before the exchange. “Swap and Drop” transactions are when the Partnership distributes the Replacement Property to the partners shortly after the exchange.

These transactions are considered aggressive since under these structures, in addition to the holding period issues above, the partnership’s prior holding period is not attributed to the individual Exchanger (the distributee of the property) who is completing the exchange. Hence, the Exchanger may be considered to be acting on behalf of the partnership, and the sale and gain recognition will be attributed to the partnership and taxed to the partnership and all its partners.

“Drop and Swap” and “Swap and Drop” transactions should only be considered with the guidance of a tax advisor.

If distributing an undivided interest of the partnership property or dissolving the partnership well in advance of the exchange is not possible, the partners who want to exchange may consider one of the following:

• Purchase of the interest of a retiring partner; or
• A partnership division

What about in the case of a purchase of the interest of a retiring partner?

This technique can be implemented before or after a 1031 exchange. Before the exchange, the partners who want to exchange contribute additional equity or bring in a new partner whose money is used to buy out the retiring partner(s). The partnership hen enters into an exchange.

How does the sale of the Relinquished Property for cash and an installment note work?

First, the buyer of the Relinquished Property pays with cash and an installment note. The partnership uses the cash in the exchange, and the retiring partner receives the installment note in redemption of his or her partnership interest. If at least one true payment is made in the following tax year, it should be considered a valid installment note and receive installment sale treatment under I.R.C. §453. Most tax advisors suggest that at least 5% of the total payments of the note be made in the next tax year.

What is partnership division?

Partnership division is a technique that can be accomplished before, after, and sometimes during an exchange. The partnership division rules of I.R.C. §708(b)(2) state that a partnership can divide into two or more partnerships. If a new partnership contains partners who owned the original partnership, it is deemed a continuation of the original partnership. Although there may be more than one “continuing partnership,” only the continuing partnership that has the greatest Fair Market Value (net of liabilities) will continue to use the Employer Identification Number (EIN) of the original partnership. All other partnerships resulting from the division will obtain a new EIN.

How can a partnership purchase multiple properties?

Although some authority exists to apply partnership division to situations where both partners want to exchange (but into separate properties), some advisors are not comfortable having their clients do so because of the holding period issues discussed above. They prefer that the partnership purchase multiple replacement properties, hold them for a sufficient period, then distribute separate properties to each partner.

Neither Pacific Premier Bank nor its divisions provide tax advice. The information herein is not intended to constitute legal, financial, or tax advice. Please consult with your tax professional regarding the possible tax consequences of a 1031 tax-deferred exchange.

Pacific Premier Trust is Affiliated with Pacific Premier Bank

That means you can access a full suite of financial solutions, including 1031 exchanges through Pacific Premier Bank’s 1031 Exchange Division.

Whether you are managing retirement assets through a self-directed IRA or looking for 1031 exchange services, Pacific Premier Trust and Pacific Premier Bank offer the expertise and support to help you navigate both. 

For further assistance or to learn more about how a 1031 exchange might benefit your specific situation, contact Teddy Marks, VP Business Development, at 303.658.3014, Monday - Friday, 7:00 a.m. - 5:00 p.m. MT.

About Pacific Premier Trust

Pacific Premier Trust, a division of Pacific Premier Bank, is a pioneer in helping investors’ utilization of retirement account funds for real estate, private equity, and other non-exchange-traded assets. As the trusted directed-custodian of over $18 billion in assets across 31,400 client accounts, Pacific Premier Trust works with financial institutions, capital raisers, financial advisors, and self-directed investors who elect to leverage tax-advantaged retirement funds in alternative investments. We deliver flexible custodial solutions ensuring a seamless client experience and unparalleled access to private markets, supported by the strength of Pacific Premier Bank. Contact us to learn more.

Legal Disclosure

Pacific Premier Trust performs the duties of an independent custodian of assets for self-directed individual and business retirement accounts and does not provide investment advice, sell investments or offer any tax or legal advice. Any communication made by Pacific Premier Trust with regard to opening or using a self-directed individual and business retirement account shall not be construed as a recommendation, call to action, or investment strategy to establish a particular account type. Clients or potential clients are in no way obligated to purchase services from Pacific Premier Trust and are free to purchase such services from any custodian they deem appropriate. Clients or potential clients are advised to perform their own due diligence in choosing any investment opportunity as well as consulting with a legal, tax and/or financial professional to assist them with an investment opportunity. Any information communicated by Pacific Premier Trust is for informational and educational purposes only. Alternative investments are not FDIC insured and are subject to risk, including loss of principal. Pacific Premier Trust is not affiliated with any financial professional, investment sponsor, or investment, tax or legal advisor.

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