1031 Exchange Planning to Restructure Family LLCs That Own Farms or Rentals

Path one: keep the LLC and exchange as one taxpayer, solving the generations' differences with the replacement mix rather than a split

A partnership or multi-member LLC is a taxpayer that may exchange real property under §1031, as IPX1031's partnership guidance confirms; the members simply cannot exchange their interests. Hypothetical: Miller Farms LLC, four members across two generations, sells 300 acres for $3,000,000 against a $600,000 basis. The LLC identifies $1,800,000 of DST interests for income and a $1,200,000 duplex portfolio for the younger members to manage, and the whole $2,400,000 gain stays deferred inside the LLC.

The strength of this path is that nothing about the taxpayer changes: no deeds to record before listing, no Court Holding argument, no holding-period question. The weakness is that everyone remains partners. DST income flows through the operating agreement, a member who wants cash creates boot at the LLC level unless bought out first, and a later distribution of a specific property to a specific member must be reported on Form 1065, Schedule B, question 11 and is tested under §704(c)(1)(B) and §737.

This path fits families content to stay together for another holding period who can write buy-sell terms, or a partnership installment note, letting the young buy out the old over time; see Partnership Installment Notes and Buyouts.

Path two: distribute tenancy-in-common shares early, drop partnership tax status, and let each member exchange or cash out on their own

Section 731(b) lets the LLC distribute the land to its members without gain to the LLC, and §731(a)(1) taxes a member only to the extent money distributed exceeds the member's basis in the interest. Each member then owns an undivided share that is real property in their own hands, and each can sign a separate exchange agreement, identify separate replacements or take cash.

Two partnership rules can turn the distribution into a taxable event. Under §704(c)(1)(B), if a member contributed the land within the past seven years and it is distributed to anyone else, the contributor recognizes the gain that was built in at contribution, and §737 mirrors that when the contributor receives other property. If the land carries a mortgage, each member's share of the debt shifts on distribution, and §752(b) treats a decrease in a member's share of liabilities as a distribution of money.

After the drop the co-owners must behave like co-owners, not partners. Rev. Proc. 2002-22 sets the pattern: no more than 35 co-owners, with spouses counted as one person and all heirs of one co-owner counted as one, no partnership return or common business name, and unanimous approval for any sale, lease or hiring of a manager. Farm co-owners who cash-rent or crop-share to a tenant fit that passive pattern; co-owners who operate the farm together look like a partnership.

Timing is the whole case: Court Holding punishes a drop after the buyer is found, and New York's 2025 Hadar ruling shows what survives

The Supreme Court's rule in Commissioner v. Court Holding Co. is that 'the incidence of taxation depends upon the substance of a transaction' and that 'a sale by one person cannot be transformed for tax purposes into a sale by another by using the latter as a conduit through which to pass title.' A tenancy-in-common deed recorded after the LLC has negotiated the sale invites exactly that argument, and IPX1031 notes that the California Franchise Tax Board challenges these structures on audit.

The taxpayer-side cases are about intent, not calendar days. In Bolker the Ninth Circuit held that a taxpayer who does not intend to liquidate or use property personally is holding it for investment even when the exchange was contracted the day the property was received, and in Magneson it upheld an exchange followed the same day by a contribution to a partnership. PLR 202416012 approved a trust's distribution of tenancy-in-common shares subject to an existing sale contract because the distribution was 'wholly independent' of the exchange.

New York's Division of Tax Appeals reached the same place in Matter of Hadar & Shomron (DTA Nos. 850122 and 850123, June 12, 2025): partners who received tenancy-in-common shares shortly before an apartment sale, two of whom exchanged, were respected as the sellers, though the decision binds only New York. The practical standard is to distribute before listing, across a tax-year boundary if you can, so each member has filed a return showing separate ownership, and to answer Form 1065, Schedule B, question 12, which asks whether the partnership distributed 'a tenancy-in-common or other undivided interest in partnership property,' truthfully for the year of the drop.

Capital accounts, buy-sell clauses and votes: match the tenancy-in-common split to what each member actually owns before anyone signs a listing

The distribution must follow the operating agreement. If the elders hold 60% of capital and the young hold 40%, a 50/50 tenancy-in-common deed is a gift or a disguised purchase, so the deed percentages should track capital accounts after any agreed adjustments. Right-of-first-refusal and buy-sell clauses often need waivers before an in-kind distribution, and the lender's consent is needed if a mortgage runs with the land.

Family members remain related persons under §267(c)(4) after the split, which shapes the replacement choices. A younger member who buys the elders' share as replacement property is acquiring from a related party that is cashing out, the pattern IPX1031 describes as denied under Rev. Rul. 2002-83; the safe pairing is elders into DST interests from an unrelated sponsor and the young into unrelated active property.

The elders' DST path has its own mechanics: minimum investment sizes, accredited-investor status and the sponsor's subscription documents, covered on DST Minimums and Sizing and Accredited Investor Requirements. Breakwater Exchange places each exchanging member into DST or direct-title offerings from vetted national sponsors and coordinates the separate exchanges with one qualified intermediary; contact is through the website form.

The file that defeats a step-transaction attack: what to have in hand before the sale closes

Auditors reconstruct intent from paper. Confirm each item with your CPA or attorney before the property is marketed.

• A dated member resolution explaining the restructure (estate planning, differing goals) that predates any listing agreement or letter of intent.
• Recorded tenancy-in-common deeds with percentages tied to capital accounts, plus lender consent.
• A co-ownership agreement drafted to Rev. Proc. 2002-22, with unanimous-consent provisions and no partnership language.
• Separate insurance, lease assignments and rent accounts for each co-owner; a final Form 1065 with Schedule B questions 11 and 12 answered, and Schedule E reporting by each co-owner afterward.
• A §761(a) election where the co-ownership is 'for investment purposes only and not for the active conduct of a business.'
• A separate exchange agreement, QI account and 45-day identification for each member who exchanges, and cash at closing for the members who do not.
• A state conformity check, since California and New York scrutinize these structures; see 1031 Exchange Rules by State.