Joint Report on IRC Section 1031
Open Issues Involving Partnerships
February 8, 2001

Contents | Introduction | I | II | III | IV | V

Introduction

The purpose of this Report is to propose answers to a number of open questions that arise in the context of partnership Section 1031¹ exchanges. The issues discussed in this Report represent questions that arise in everyday practice and have not been resolved by published guidance.

Many like kind exchanges are undertaken regularly by taxpayers of relatively modest means. Many of these exchanges are frequently consummated by partners with property distributed to them by partnerships in anticipation of an exchange. The goal of this Report is to encourage the Internal Revenue Service to issue guidance that addresses areas of concern to taxpayers attempting to understand and apply Section 1031 in a partnership context.

It is common for taxpayers holding property through a partnership (including limited liability companies treated as partnerships for income tax purposes) to attempt: (i) to dissolve and liquidate the partnership in order to permit each partner to separately sell or consummate a subsequent Section 1031 exchange, (ii) to distribute undivided interests in the relinquished property to some partners to allow partner-specific 1031 exchanges, or (iii) to use special allocations at the partnership level to reflect the scope of participation by specific partners in partnership level exchanges.

Clarification is needed of the legal standards to be applied when: (i) a relinquished property was formerly held by a partnership and distributed to one or more partners in anticipation of an exchange, (ii) a relinquished property is held by a partnership and only some of the partners desire to participate (indirectly) in the exchange, and (iii) a replacement property received in an exchange is transferred to a partnership. In our experience, each of these transactions are common and existing guidelines do not lead to clear conclusions. Further, published guidance also does not address how Section 752(b) and Section 465 should be applied in the context of exchanges.

The liquidation of an entire partnership and the distribution of co-tenancy interests in a prospective relinquished property can be successfully accomplished for income tax purposes, but for commercial reasons such transactions are often complicated and represent an unduly expensive route for preparing for a Section 1031 exchange. For example, a closely held partnership holding encumbered and improved real estate must typically obtain lender consent before liquidating and distributing co-tenancy interests to its former partners. Property management issues involving tenants of the prospective relinquished property and vendors of various services to the property often complicate resulting co-tenancy arrangements.

Tax characterization issues also complicate the day-to-day operations of a co-tenancy arrangement because of the uncertainty about the scope of a valid protective Section 761 election out of Subchapter K.

Such complications often compel taxpayers to seek other means of accomplishing the same end result: a Section 1031 exchange.

Many of the legal issues confronting taxpayers would become irrelevant or far less important if the "qualified use"² standard for Section 1031 exchanges was clarified to make clear that: (i) qualified use by a distributing partnership or a contributing partner can be attributed to the distributee partner or recipient partnership where the new owner’s basis is determined by reference to the old owner’s basis and (ii) by recognizing that partnership level exchanges with boot can be combined with valid Section 704(b) allocations to effectively retire or partially liquidate the interest of a partner with boot proceeds.

This report is presented in a question and answer format to identify the commonly encountered issues in applying Section 1031 in the partnership context. The answers represent the recommended clarification to address these partnership Section 1031 open issues.

Contents | Introduction | I | II | III | IV | V