How to minimize taxes when dissolving partnership

Member since 2025 · 3 posts · 3 votes

We are starting the process of dissolving our investment business (LLC) that has two partners. We know we have to sell 1 property, but the rest will probably be distributed equally. My question is when we sell the property, is there a way for each partner to individually defer the capital gains tax? Normally we'd use a 1031 exchange, but since the cash of that property is going to be split, I wasn't sure what our options are.

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Ben TrageserPro Member

Accountant · Montclair, NJ · Member since 2020 · 218 posts · 104 votes

Quote from @Daniel Osman:

Hi Clark,

Before selling the property, the LLC can distribute the property to the partners as tenants in common. This involves converting the partners' interests in the LLC into direct ownership of the property. Once the property is owned directly by the partners, each partner can individually decide to engage in a 1031 exchange with their share of the property. This method allows each partner to defer capital gains tax on their portion of the property.

It's important to perform the "drop" (distribution of property to partners) well in advance of the "swap" (sale or exchange) to comply with the "held for investment" rule. The IRS has challenged simultaneous "drop and swaps," so allowing some time between these steps is advisable.

You hit this right on the head with your answer with TIC.

You could also potentially do a Exchange Post Distribution (Swap and Drop). For this strategy you would distribute the property to partners based on their ownership share, dissolve the LLC and then partners collectively sell the property. Each partner could then individually complete a 1031 EXCH by assigning their interest to a QI. As this is a little tricky, I would recommend speaking with a 1031 QI first.

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Daniel Osman
Accountant · 1031 Exchange Qualified Intermediary | Nationwide · Member since 2024 · 53 posts · 32 votes
1y
Hi Clark,
Before selling the property, the LLC can distribute the property to the partners as tenants in common. This involves converting the partners' interests in the LLC into direct ownership of the property. Once the property is owned directly by the partners, each partner can individually decide to engage in a 1031 exchange with their share of the property. This method allows each partner to defer capital gains tax on their portion of the property.

It's important to perform the "drop" (distribution of property to partners) well in advance of the "swap" (sale or exchange) to comply with the "held for investment" rule. The IRS has challenged simultaneous "drop and swaps," so allowing some time between these steps is advisable.
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Clark Harbaugh
OP
Member since 2025 · 3 posts · 3 votes
1y
Quote from @Daniel Osman:

Hi Clark,
Before selling the property, the LLC can distribute the property to the partners as tenants in common. This involves converting the partners' interests in the LLC into direct ownership of the property. Once the property is owned directly by the partners, each partner can individually decide to engage in a 1031 exchange with their share of the property. This method allows each partner to defer capital gains tax on their portion of the property.

It's important to perform the "drop" (distribution of property to partners) well in advance of the "swap" (sale or exchange) to comply with the "held for investment" rule. The IRS has challenged simultaneous "drop and swaps," so allowing some time between these steps is advisable.

Thanks. That is our plan with all but 1 property. It has to be sold prior to dissolving the company to clear the debt against it and free up cash.
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Daniel Osman
Accountant · 1031 Exchange Qualified Intermediary | Nationwide · Member since 2024 · 53 posts · 32 votes
1y
Thanks for clarifying that.

Depending on how much time you have before needing to dissolve the partnership, the partnership can sell all the properties and complete 1031 exchanges to defer the capital gains tax.

After the exchanges are completed, the partnership can distribute the replacement properties to the partners as tenants-in-common via a swap and drop.

The more time that passes between the exchange and the distribution, the better. The IRS may scrutinize such transactions, especially if the "swap and drop" occurs too close in time.

If the partnership has to be dissolved immediately it will be tough to sell the one property and defer taxes individually.
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Ben TrageserPro Member
Accountant · Montclair, NJ · Member since 2020 · 218 posts · 104 votes
1y
Quote from @Daniel Osman:

Hi Clark,
Before selling the property, the LLC can distribute the property to the partners as tenants in common. This involves converting the partners' interests in the LLC into direct ownership of the property. Once the property is owned directly by the partners, each partner can individually decide to engage in a 1031 exchange with their share of the property. This method allows each partner to defer capital gains tax on their portion of the property.

It's important to perform the "drop" (distribution of property to partners) well in advance of the "swap" (sale or exchange) to comply with the "held for investment" rule. The IRS has challenged simultaneous "drop and swaps," so allowing some time between these steps is advisable.

You hit this right on the head with your answer with TIC.

You could also potentially do a Exchange Post Distribution (Swap and Drop). For this strategy you would distribute the property to partners based on their ownership share, dissolve the LLC and then partners collectively sell the property. Each partner could then individually complete a 1031 EXCH by assigning their interest to a QI. As this is a little tricky, I would recommend speaking with a 1031 QI first.
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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
1y
@Clark Harbaugh, Given the favorable tax rulings over the last few years (in particular revolving around trusts and their equaling a beneficial interest in the underlining propery) the IRS has actually been much more lenient (or at least silent) on these issues. these rulings over the last 10 years have eliminated much of the angst seen around the "hold for investment" issue mentioned above.
Dissolving the LLC and distributing the property to the former members as tenants in common and then selling is a relatively common practice in these situations. Each former member is then free to either do a 1031 on their % interest or take the cash and pay the tax.
The opposite manuever was more common until around 15 years ago. It is what was called the "swap and drop". The LLC sells the subject property and buys, for example, 3 replacement properties in a 1031 exchange. Once the 1031 is complete the LLC dissolves and again the property is distributed to the former members, including the properties just purchased in the 1031 exchange (which each member probably picked out for themselves).
This method solved the feared "held for investment" issue. But did create issues of determination of value when distributing the assets of the LLC because all properties are probably not exactly equal in value or equal to a members % interest.
But either of these can be made to work for you in the situation you describe.
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Basit SiddiqiBusiness Member
Accountant · New York, NY · Member since 2015 · 8k+ posts · 3k+ votes
1y
You may want to see if each partner has enough passive loss carryforward to offset the gain.
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Clark Harbaugh
OP
Member since 2025 · 3 posts · 3 votes
1y
Quote from @Basit Siddiqi:

You may want to see if each partner has enough passive loss carryforward to offset the gain.

That's an interesting thought. I'll look into this scenario. Thanks
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Jason MalabuteBusiness Member
Accountant · Los Angeles, CA · Member since 2016 · 2k+ posts · 912 votes
1y
When dissolving your two-member LLC and selling a property, deferring capital gains taxes individually can be complex. A standard 1031 exchange requires that the same entity selling the property also acquires the replacement property, which becomes challenging when proceeds are split between partners.

Potential Strategy: "Drop and Swap"

One approach is the "Drop and Swap" method:
1. - Convert Ownership: Before the sale, the LLC distributes the property to the partners, converting joint ownership into individual tenants-in-common (TIC) interests.
2. - Individual 1031 Exchanges: Each partner can then independently conduct a 1031 exchange with their share, deferring capital gains taxes by reinvesting in like-kind properties.
Considerations:
- - Timing: The IRS may scrutinize transactions where the "drop" (distribution) and "swap" (exchange) occur in quick succession. Holding the property as TIC for a period before the exchange can demonstrate intent to hold for investment.
- - Legal and Tax Implications: This strategy involves intricate legal and tax details. It's crucial to consult with professionals experienced in 1031 exchanges and partnership dissolutions to ensure compliance and optimize tax deferral.
Given the complexities, seeking personalized advice from a tax advisor or attorney is highly recommended.
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Ashish AcharyaBusiness Member
CPA, CFP®, PFS · Sarasota, FL · Member since 2017 · 5k+ posts · 3k+ votes
1y
@Clark Harbaugh When dissolving an LLC with multiple partners, minimizing taxes depends on how assets are distributed. If you sell a property, capital gains tax applies based on each partner’s ownership share, and a standard 1031 exchange won’t work if proceeds are split, as the exchange requires continuity of ownership in a like-kind investment.

One strategy is a drop-and-swap, where the LLC distributes the property to partners as tenants-in-common (TIC) before the sale, allowing each to complete a separate 1031 exchange. However, the IRS may scrutinize exchanges if the holding period post-transfer is too short (typically 12-24 months recommended).

If one partner wants to defer capital gains while the other prefers cash, the deferring partner could reinvest their share into a Qualified Opportunity Zone (QOZ) fund, which can defer and reduce taxable gains if held for at least 10 years. Another option is an installment sale, which spreads capital gains tax over multiple years.

For unsold properties being distributed, there is generally no immediate tax event if assets are transferred at their adjusted basis. However, when the new owner sells, they will owe capital gains tax based on their share of the basis.

Given the complexity and IRS scrutiny of 1031 exchanges and drop-and-swap strategies, consult a CPA or attorney specializing in partnership taxation to ensure compliance and maximize tax savings.
This post does not create a CPA-Client relationship. The information contained in this post is not to be relied upon. Readers should seek professional advice.
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