1031 Exchange When Only One Partner Wants to Cash Out

‘I’ll just exchange my third’ fails because the LLC sold the building and your third is an entity interest

Reg. §1.1031(a)-3(a)(5)(i) lists what counts as real property for §1031 and then carves out ‘interests in a partnership’, sparing only a partnership with a valid §761(a) election. Asset Preservation states the consequence directly: partners ‘merely own partnership interests, and partnership interests are not real property’ (Partnerships).

The entity that signs the deed is therefore the only taxpayer that can identify and buy replacement property, and the proceeds belong to it, not to the members pro rata. Your problem is one of structure, and each fix below changes who owns what before or after the closing.

Throughout this page the example is a $3,000,000 sale by a three-member LLC with an adjusted basis of $900,000, where one member wants $1,000,000 in cash and the other two want to defer their share of the $2,100,000 gain.

Route 1: the entity keeps $1,000,000 in cash and all three members pay tax on gain they did not receive

The simplest route is for the LLC to instruct the intermediary to release $1,000,000 at closing and send $2,000,000 into the exchange. That $1,000,000 is boot, so the LLC recognises $1,000,000 of its $2,100,000 gain, and the Form 8824 instructions have the entity report it on its own return before it flows through on Schedules K-1.

Unless the operating agreement contains an allocation that satisfies the substantial-economic-effect test of §704(b), the gain is shared under the agreement’s normal ratios, so the two continuing members each report about $333,000 of gain while the departing member walks away with the cash. Asset Preservation describes the same problem: the cash ‘would require the partnership to allocate the resulting gain among all of the partners’.

A special allocation of the boot gain to the departing member is possible on paper, but it must track the economics in the capital accounts, and drafting it after the contract is signed is exactly the kind of retroactive allocation examiners test.

Route 2: a partnership installment note moves the whole $700,000 of gain to the member who leaves

Instead of $1,000,000 in cash, the LLC accepts a $1,000,000 note from the buyer and distributes that note to the departing member in complete redemption of his interest. Reg. §1.1031(k)-1(j)(2)(iii) treats a note received through the intermediary as ‘an evidence of indebtedness of the person acquiring property from the taxpayer’, so it qualifies for the installment method of §453 provided at least one payment falls after the year of sale.

§731(b) says no gain is recognised by a partnership on a distribution, and Reg. §1.453-9(c)(2) exempts a §731 distribution of an installment obligation from the gain-on-disposition rule. The departing member takes the note with a basis equal to his outside basis under §732(b), here $300,000, and reports $700,000 of gain as the buyer pays.

The LLC then exchanges the remaining $2,000,000 into replacement property worth at least that much. Asset Preservation warns against it where the leaving member owns a large percentage or the building is heavily mortgaged, and the departing member must be willing to be paid after closing rather than at it; the mechanics are on our partnership installment note page.

Route 3: deed the departing member a one-third TIC interest before the sale so he sells for cash on his own

Here the LLC distributes an undivided one-third interest to the departing member, or to a single-member LLC he owns, before any contract is signed. §731(a)(1) taxes him only if money distributed exceeds his basis, so a deed of real estate produces no gain, and Legal 1031 lists the follow-up: ‘The new co-owner (exiting partner) will report their share on schedule C of their personal tax return’, and the partnership ‘will only have to purchase property for its share of Net Sales Price’.

At closing the buyer pays $1,000,000 to the former member, who reports his own gain, and $2,000,000 to the intermediary for the LLC, which never changed its investment intent because it kept and sold what it always owned. The risk is timing: if the distribution follows a signed sale contract, the IRS can argue the LLC sold the whole building and the member’s $1,000,000 is entity-level boot after all, the substance argument that carried Chase v. Commissioner, 92 T.C. 874 (1989).

Two more checks before you deed anything: lender consent, which Legal 1031 flags as a hurdle to any title change, and the seven-year rules in §704(c)(1)(B) and §737 if the building or a member’s capital was contributed to the LLC less than seven years ago.

Route 4: exchange all $3,000,000 now, refinance the replacement later and redeem him with loan proceeds

Legal 1031’s second option keeps the partnership whole through the exchange: the entity buys replacement property with ‘100% of Net Sales Price’, then the remaining members or a new lender fund a buy-out of the departing member afterwards. Cash distributed to him in redemption is taxed under §731 to the extent it exceeds his outside basis, and the continuing members’ deferral is untouched.

The exposure is a refinance arranged before the exchange closes, which examiners can recast as cash taken out of the exchange; our guide on refinancing before or after a 1031 covers the spacing that advisers recommend. The departing member also has to trust the others to complete a loan he does not control.

This route suits friendly partners with an unleveraged or lightly leveraged building and a lender willing to underwrite the new property at a loan-to-value that produces the buy-out cash.

Picking the route by time to contract, leverage and how the partners get along

Match the structure to the facts you cannot change, then design the exchange around it. Have your CPA and a tax attorney sign off on the chosen route before the listing agreement, because two of the four depend on steps taken before a buyer appears.

• More than a year before listing, friendly partners: the TIC drop (Route 3), which gives the departing member his own taxpayer status and leaves the entity’s exchange clean.
• Already under contract or in escrow: the installment note (Route 2), which Legal 1031 calls ‘an ideal strategy for ending unfriendly relationships’, or the cash-boot route with a defensible allocation.
• High mortgage balance relative to equity: entity-level boot or the refinance route, because a note large enough to redeem the member may not fit inside the equity.
• Departing member who needs cash on the closing date: Route 1 is the only one that pays him at the table, at the price of gain shared by everyone.
• For the two members who stay, we can place the entity’s $2,000,000 into DST interests, triple-net properties or other replacement options before day 45 so that the departure never threatens the deadline.