Partnership Issues

Interests in a Partnership

The IRS had attempted to preclude the exchange of partnership interests by promulgating R.R. 78-135. However, the courts consistently rejected this position (Gulfstream Land & Dev. Crop., 71 TC 587 (1979); Arthur E. Long, 77 TC 1045 (1981); and Peter N. Pappas, 78 TC 1078 (1982)). The IRS was more successful with Congress.  The Tax Reform Act of 1984 added partnership interests to the list of types of property specifically excluded from exchange treatment (1031(a)(2)(D)). The provision applies to exchanges closed after March 31, 1984, except for exchanges under a binding contract in effect on March 1, 1984, that remains continuously in effect until the exchange. It appears that the prohibition on exchanges of partnership interests does not apply to exchanges of interests in the same partnership, but only to exchanges of partnership interests in different partnerships  (H.R. Report. No. 98-432, 98th Cong, 2d (1984)).

Note: The exclusion of partnership interests from 1031 causes concern for co-tenants. While Reg. 1.761-1(a) states that the mere co-ownership of property does not constitute a partnership, co-tenants may be partners if
they actively carry on a trade or business. In any event, no partnership return should be filed (if necessary, an election out of partnership treatment under 761(a) should be made) and the co-tenants should individually report their
pro rata shares of income and deduction. See also M.H.S. Co., TC Memo 1976-165 for further discussion of co-tenancy versus partnership.

Existing Partnerships

A 761(a) might be a good solution for co-tenants who have previously filed
 partnership tax returns. Section 761(a) permits an "unincorporated organization" to elect out of partnership treatment provided:

 (i) The organization is used for investment purposes only and not for the
 active conduct of a trade or business, and

(ii) The income of the members of the organization can be determined without computation of partnership income.

Thereafter, an exchange of interests in such an organization should be treated as an exchange of the underlying assets.

1991 Final Regulations

The Tax Reform Act of 1984 prohibited the exchange of partnership interest. Thus, 1031(a)(2)(D) provides that 1031(a) does not apply to any exchange of interests in a partnership. The regulations apply this rule whether the partnership interests exchanged are general or limited or are in the same partnership (Reg. 1.1031(a)-1(a)(1. However, this provision does not affect the conversion of partnership interests in the same partnership under R.R. 84-52.

Note: House and Senate Reports to the '84 Act state that the rule barring
tax-free exchange treatment for partnership interests does not apply to e-
canes of interests in the same partnership.

The proposed regulations stated that no inference was intended with respect
to whether an exchange of an interest in an organization that has elected under 761 to be excluded from the application of subchapter K was eligible for nonrecognition of gain or loss under 1031.

 Note: Section 761 allows certain investment and operating groups to "elect out'. of subchapter K (701 through 761), which prescribes the manner in  which partners are taxed. Taxpayers who elect out are thus no longer subject  to those rules. According to 1984 Act "Blue Book", the rule barring tax-free exchanges of partnership interests "is not intended to apply to organizations which have elected, under 761(a), not to be subject to the provisions of Subchapter K of the Code; instead, an exchange of interests in such organizations would be treated as an Inspective and the applicability organizations on the basis of those exchanges." In 1990, the Budget Reconciliation Act amended 1031(a)(2) to provide that an interest in a partnership that has in effect a valid election under 761(a ) to be excluded from the application of all of subchapter K is treated under 1031 as an interest in each of the assets of the partnership and not as an interest in a partnership. The final regulations reflect this amendment to 1031.

The amendments to 1031(a)-1 made in the final regulations with respect to
exchanges of partnership interest are effective for transfers of property made
by taxpayers on or after April 25, 1991.

Splitting Partners

While the exchange of partnership interests is prohibited (1031(a)(2)(D), a
partnership can exchange property with another partnership, individual, or other
entity and still be entitled to nonrecognition under 1031. However, a frequent problem is when one or more partners want to be cashed out as part of an exchange by the partnership. The following methods of effecting such a division may be tried, but it is unclear whether the Service or the courts will uphold them: 9-11

Historically, the Service has required the taxpayer to hold both the property put
into the exchange and the property taken out of the exchange for the qualified purposes (R.R. 75-291; R.R. 75-292 & R.R. 77-337). Implicit in this requirement
is that the taxpayer must go in and out of the exchange as the same taxpayer or
entity.  However, some cases have challenged this position! Traditionally, a taxpayer could not go into the exchange as individual and come out as a corporation, partnership, trust, estate or other separate entity. Until recently there has been no "Doctor Jekyll - Mister Hyde" corollary under 1031.  You could not go into the exchange transaction as a cater-pillar and exit a butterfly . 

For more information on this matter or if we may be of further assistance please contact us for a free consultation by calling us at 1 (800) 781-1031 or (714) 939-1031 or by e-mail at

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