A 1031 exchange is a way of deferring capital gains taxes on the sale of real estate. Taxpayers who sell property held for investment purposes can defer the taxes by directing the proceeds from the sale into "like-kind" property of the same or greater value, also to be used for investment. In practice, almost any investment property has been considered “like-kind” by the IRS.
For example, an investor can sell a rental house and purchase an office building, or vice versa. Likewise, they can sell a retail property and purchase multi-family housing or sell self-storage units and buy an industrial facility. Despite the flexible interpretation of this aspect of the code section, the IRS is not as generous concerning the other portions, which have tight deadlines and qualifications. The requirements for a 1031 exchange include the following:
If investors hold property as a pooled interest through partnership, the assets are owned by the partnership, not by the partners. Owning real estate within a partnership may have certain advantages since the partnership structure can protect individual partners. In addition, the partnership typically passes the income tax liability through to the individual partners. Also, pooling capital or borrowing capacity may allow investors to reach their ownership goals.
However, according to the IRS, the partnership interests are personal property and not considered "like-kind" to real estate. As a result, a partnership can transact a 1031 exchange. Still, the individual partners can't exchange their property shares for other "like-kind" assets because their partnership shares are not real estate assets.
The most straightforward approach when partners have diverging goals is to dissolve the partnership and sell the shared asset. Each partner would be responsible for the taxes due on their share. If only one or a small number of partners wants to leave, it's possible that the remaining partners can buy out the ones wishing to depart. Departing investors would pay taxes on their shares.
If the partnership is pursuing a 1031 exchange while one or more partners are exiting the partnership, the transaction becomes more exposed to IRS scrutiny. Therefore, it is better to wait 24 months after completing an exchange before leaving a partnership.