Partnerships

One wants cash, one wants to exchange into a different asset class, and one wants to keep going as before. The partnership can exchange, but a partnership can only exchange into one thing, and the partners want three.

The techniques developed to solve this problem, drop and swap and its mirror image, rest on judicial authority that is favorable, geographically concentrated, and not accepted by the Service. A practitioner should understand exactly how much weight that authority will bear, because this is the area where confident advice is least warranted.

20.1 The partnership is the taxpayer

A partnership interest is not real property. The regulation excludes interests in a partnership from the intangible assets that qualify, expressly regardless of State or local characterization, subject to one carve-out taken up at 20.5.¹

That exclusion, combined with the same-taxpayer requirement of Chapter 18, produces the constraint that generates everything else in this chapter. The partnership holds the property, so the partnership is the taxpayer, so the partnership must be the party that exchanges. A partner cannot exchange out of a partnership interest, and a partner cannot take replacement property individually when the partnership relinquished.

A partnership may of course exchange in the ordinary way, and where all partners are content with the same replacement property that is the clean answer. The difficulty is unanimity. The exchange decision belongs to the entity, and a partner who wants cash must either be bought out or must persuade the others.

Two structures respond to the difficulty. Convert the partners into direct owners before the exchange, or exchange at the partnership level and separate afterward. Each has a name, a leading case, and an unresolved question.

20.2 Drop and swap

In a drop and swap, the partnership distributes the property to its partners as tenants in common before the sale. Each former partner then holds an undivided interest in real property directly, and each may do as they wish: exchange, or sell and pay tax.

The mechanics are ordinary partnership tax. A distribution of property is generally not a taxable event to the partnership or the partners, and the distributee takes a basis determined under the distribution rules.² After the distribution the partnership may terminate or continue, depending on what remains.

The tax question is not the distribution. It is whether the distributee partners satisfy the holding requirement of Chapter 12, having owned their undivided interests for perhaps a day.

The authority relied upon is Bolker v. Commissioner, examined at 12.3.³ Its formulation is that a taxpayer who owns property he does not intend to liquidate or to use for personal pursuits is holding it for productive use in a trade or business or for investment. On that test a partner who receives a tenancy in common intending to exchange it qualifies, because an intent to exchange is neither liquidation nor personal consumption, and the holding period is irrelevant.

Two limits on that reliance should be stated plainly.

Bolker was a corporate liquidation case, not a partnership distribution case. The taxpayer received property in a corporate liquidation and exchanged it the same day. Its formulation is applied to partnership distributions by analogy, and the analogy is natural, but it is an analogy rather than a holding.

Bolker is a Ninth Circuit decision. A Maryland taxpayer litigating in the Fourth Circuit, or in the Tax Court on an appeal that would lie to the Fourth Circuit, is not within its precedential reach.

20.3 Swap and drop

The mirror technique reverses the sequence. The partnership completes the exchange, acquiring replacement property in its own name, and afterward distributes interests to the partners who wish to separate.

Here the question is the acquisition side of the holding requirement. Did the partnership acquire the replacement property intending to hold it for investment, when it intended from the outset to distribute it?

Magneson v. Commissioner is the leading authority and it runs in the taxpayer's favor.⁴ The taxpayers exchanged a fee interest for another fee interest and, on the same day, contributed the acquired property to a limited partnership in return for a general partnership interest. The Commissioner argued they had not held the replacement property for investment. The Ninth Circuit disagreed, reasoning that the contribution was "a continuation of the Magnesons' investment unliquidated but in a modified form," and that the crucial question under section 1031(a) is continuity of investment in like-kind property.⁵

The symmetry with Bolker is worth pausing on, because it explains why practitioners in the Ninth Circuit treat this area as comfortable and practitioners elsewhere do not. Both cases are Ninth Circuit. Both involve same-day transactions. Both were decided in 1985. And both rest on the same idea: what matters is whether the taxpayer's investment continued in some form, not whether the taxpayer held a particular title for a particular period. Read together they make the sequence largely irrelevant in that circuit, which is precisely the proposition the Service resists.

20.4 The unresolved question

A treatise should be candid about the state of this area, and the candid statement is that the technique is widely used, rarely challenged, favorably supported in one circuit, and not conceded by the Service.

Four observations frame the risk.

There is no statutory or regulatory holding period, as Chapter 12.4 established, so the Service cannot point to a violated rule.⁶ Its argument is that the partners never held for investment at all, which is a facts-and-circumstances contention.

The step transaction doctrine is the Service's natural instrument. Where a distribution and an exchange are executed under a single plan on a single day, the argument that they should be collapsed into a partnership-level disposition followed by a distribution of proceeds is not frivolous. Chapter 42 develops the doctrine.

The Service has made its interest visible through return reporting. Partnership returns inquire about distributions of tenancy-in-common interests and about section 1031 activity, which supplies a selection mechanism regardless of the merits.

The practical risk gradient tracks time and formality. A distribution executed well before the property is marketed, with the co-tenants genuinely operating as co-owners under a tenancy in common agreement, filing consistently, and making independent decisions, presents a materially stronger record than a distribution executed at the closing table.

The counsel that follows is not that the technique should be avoided. It is that the client should be told, in writing, that the position rests on analogy and on out-of-circuit authority, and that the interval between the drop and the swap is the single variable most within the client's control.

20.5 The section 761(a) election

An alternative avoids the problem rather than managing it, and it is underused.

Section 1031(e) provides that an interest in a partnership that has in effect a valid election under section 761(a) to be excluded from the application of all of subchapter K is treated as an interest in each of the assets of the partnership.⁷ The regulation carries the same carve-out in the exclusion of partnership interests.⁸

Where the election is in place, each participant is treated as owning an undivided interest in the underlying real property. There is nothing to drop, because no one holds a partnership interest to begin with. Each participant may exchange independently.

The election is not available to every arrangement. Section 761(a) permits exclusion where the participants are engaged in investment purposes rather than the active conduct of a business, or in the joint production, extraction, or use of property, and where their income can be adequately determined without computing partnership taxable income. An operating venture with active management, employees, and business activity does not qualify, and an arrangement that has been filing partnership returns for years and providing services to occupants is unlikely to fit.

Where it does fit, it should be considered at formation rather than at exit. An election made when the venture is organized supplies a clean structure for the entire life of the investment. An election attempted on the eve of a sale invites the same step transaction scrutiny as a drop and swap, with the added difficulty of explaining the change in position.

20.6 Consequences that outlast the restructuring

Two downstream effects deserve mention because they are frequently discovered after the fact.

Built-in gain allocations do not disappear. Where property was contributed to the partnership with a difference between basis and value, subchapter K requires that the built-in gain be allocated to the contributing partner.⁹ Restructuring the ownership does not extinguish that history, and a distribution followed by separate exchanges can produce allocations that surprise the participants.

Debt shifts produce recognition. A partner's share of partnership liabilities is treated as a contribution or distribution of money as it changes, and a restructuring that reallocates debt among the participants can generate recognized gain independent of anything section 1031 does. Where the property is encumbered beyond its basis, this is the most common source of unexpected tax in an otherwise successful drop and swap, and it should be modeled before the distribution rather than discovered on the return.¹⁰

The co-ownership structures that result from these techniques, and the conditions under which a tenancy in common avoids being recharacterized as a partnership all over again, are the subject of Chapter 21.