Can a partnership do a 1031 exchange?

Yes, but it is more complex than an individual exchange. Section 1031 does not apply to exchanges of partnership interests, so the partnership itself must conduct the exchange, or partners may use drop and swap or swap and drop techniques to convert partnership interests into direct ownership before or after the exchange.

What is a disguised sale in partnership tax?

A disguised sale occurs when a partner contributes property to a partnership and receives a distribution within two years that is treated as part of a prearranged sale. If found, the partner recognizes gain as if they sold the property directly. This is particularly relevant when partnerships refinance contributed property and distribute proceeds.

Tax Consequences of Real Estate Held in LLCs and Partnerships | Lynch Law

Holding real estate in an LLC taxed as a partnership is one of the most common structures for real estate investors, and for good reason—the partnership tax rules provide flexibility in allocating income, deductions, and credits among partners. But the partnership taxation of real estate involves a number of complex rules that can create unexpected tax consequences if not properly managed. Business owners who hold real estate through LLCs need to understand these rules before making decisions about contributions, distributions, refinancings, and dispositions.

Section 704(c) Built-In Gain Allocations

When a partner contributes appreciated real estate to a partnership, Section 704(c) requires the partnership to allocate the built-in gain to the contributing partner when the property is sold. This prevents the contributing partner from shifting pre-contribution gain to other partners. The partnership must choose one of three allocation methods—traditional, traditional with curative allocations, or the remedial method—each of which produces different results for the contributing and non-contributing partners.^[1]

The 704(c) rules also apply to depreciation allocations. Contributed property with built-in gain carries less tax basis than book value, which means the contributing partner receives less depreciation than their economic share. This "ceiling rule" limitation can be addressed with curative or remedial allocations, but the partnership agreement must specifically provide for the chosen method.

Disguised Sale Rules

When a partner contributes property to a partnership and receives a distribution within two years, the transaction may be recharacterized as a disguised sale under Section 707(a)(2)(B). If a disguised sale is found, the contributing partner recognizes gain as if they had sold the property directly, and the partnership is treated as having purchased it. The two-year presumption can be rebutted, but the partner bears the burden of proving that the contribution and distribution were not part of a prearranged plan.^[2]

The disguised sale rules are particularly relevant when property is contributed to a partnership that then refinances the property and distributes the debt proceeds to the contributing partner. The IRS will scrutinize these transactions closely, and the partnership should be prepared to demonstrate a business purpose for the refinancing independent of the distribution.

Section 1031 Exchange Complications

Like-kind exchanges under Section 1031 can be used to defer gain on the sale of real property, but the rules are more complex when the property is held in a partnership. Section 1031 does not apply to exchanges of partnership interests, so partners cannot simply exchange their partnership interests for other property. Instead, the partnership itself must conduct the exchange, or the partners must take steps to convert their partnership interests into direct ownership of the property before the exchange.^[3]

Common techniques include the "drop and swap" (the partnership distributes the property to the partners, who then conduct individual 1031 exchanges) and the "swap and drop" (the partnership conducts the exchange and then distributes replacement property to the partners). Both techniques have been upheld by courts and the IRS, but the timing and documentation requirements are critical.

Depreciation Recapture

When depreciable real property is sold, the gain attributable to prior depreciation deductions is recaptured as ordinary income under Section 1250 (at a maximum rate of 25% for unrecaptured Section 1250 gain). In a partnership context, the depreciation recapture must be allocated to the partners who received the depreciation deductions, which may differ from the partners' general profit-sharing ratios if special allocations were made.^[4]

Real estate investors should work closely with their tax advisors to understand the partnership tax implications of real estate transactions before executing them, as many of these rules create traps for the unwary that are difficult or impossible to correct after the fact.^[5]

References

^[1] IRC § 704(c); Treas. Reg. §§ 1.704-3(b), (c), (d) (traditional, curative, and remedial allocation methods for contributed property with built-in gain).
^[2] IRC § 707(a)(2)(B); Treas. Reg. § 1.707-3 (disguised sale rules for contributions followed by distributions within two years).
^[3] IRC § 1031(a)(2)(D) (excluding partnership interests from like-kind exchange treatment); see Magneson v. Comm'r, 753 F.2d 1490 (9th Cir. 1985).
^[4] IRC § 1250 (depreciation recapture for real property); § 1(h)(1)(E) (25% rate on unrecaptured Section 1250 gain).
^[5] See Tax Controversy & IRS Defense (discussing partnership tax issues and IRS audit defense).