Section 1031 specifically does NOT allow the acquisition of a partnership interest as the replacement property for a 1031 exchange. However, in a just-released private letter ruling, the IRS did allow a taxpayer to purchase a partnership as the replacement property. Private letter rulings technically apply only to a specific taxpayer, but in some cases, such as this one, they provide a great deal of guidance on how to structure a similar transaction.

In this ruling, the taxpayer did an exchange and wanted to acquire a property owned by a limited partnership. For reasons not disclosed in the ruling, the course of action for this transaction was to acquire the individual partnership interest of each partner rather than the property owned by the partnership. In other words, the taxpayer wished to have the partnership continue as the owner of the property, and wrote to the IRS requesting guidance on the structuring of the transaction. The ruling doesn’t say why the taxpayer wanted to keep the partnership on title to the property, but one obvious reason might be that the partnership had a loan on the property (probably non-recourse) that the buyer wanted to keep intact. Or perhaps the loan had a tough prepayment clause that would have screwed up the economics of the transaction if the partnership sold the property and paid off the loan.

To solve the problems posed by this transaction, the taxpayer ended up creating a single member LLC to take title to the general partnership interest in the transaction. Single member LLCs are considered disregarded entities by the IRS. A disregarded entity is just that – an entity that the IRS ignores. You don’t file an income tax return for a single member LLC, and all of the income and expenses associated with the property is reported in the tax return of its owner (in this case, the taxpayer).

The limited partnership interests in the partnership were acquired by the taxpayer directly as the replacement property for the exchange. So the ownership of the partnership, after the acquisition, had the taxpayer’s single member LLC owning the general partnership interest, and the taxpayer owning the limited partnership interests. In summary, the taxpayer owned 100% of the New Property, and since this was the same taxpayer that sold the Old Property, the transaction met the requirements of a 1031 exchange. What makes this transaction work is that by acquiring 100% of the partnership interests in a single transaction, the taxpayer is truly the actual owner of this property. Had the taxpayer acquired less than 100% of the partnership, the exchange would have failed.

There’s an additional interesting benefit of structuring the transaction this way that wasn’t mentioned in the ruling: when the dust settles, the taxpayer manages to limit it’s liability on the property by having the general partnership interest owned by an LLC, with the balance of the property owned by limited partnership interests. Both LLCs and limited partnership interests protect the owner from liability. Had the taxpayer, as an individual, taken title to the property, it would not have been protected.