A partnership may exchange property for other property of “like kind.” However, IRC Section 1031(a)(2)(D) specifically prohibits exchanges of partnership interests. This means that an 1031 Exchanger cannot buy into or sell interests in a partnership and qualify for a §1031 exchange. The rationale is that a partnership interest [along with a real estate investment trust (REIT) share] itself is personal property and thus is not “like kind” with real property. Given these facts, what alternatives are available to 1031 Exchangers?
First, investors owning a property together must determine if they really own the property in a true “partnership.” Often, investors who own property with others may consider the other individuals their “partners” even though they hold title as an undivided interest and don’t file a partnership tax return, thus they are merely “co-owners.” The test is generally, “do the owners hold title as “tenants-in-common?”
One option is that the entire partnership stays intact and exchanges the relinquished property for a replacement property, the property can be refinanced and the proceeds are distributed to the partner who wants to cash out.
Another alternative is that the partnership has a valid election out of subchapter K under IRC §761. The partner seeking to cash out sells their undivided interest and the other partner exchanges their tenancy-in-common interest for a replacement property. (Note: There are risks associated with partnership issues that must be discussed with a legal and/or tax advisor.)