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 Section 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.
A Section 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:
Thereafter, an exchange of interests in such an organization should be treated as an exchange of the underlying assets.
The Tax Reform Act of 1984 prohibited the exchange of partnership interest. Thus, Section 1031(a)(2)(D) provides that Section 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 exchange 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 (Sections 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 the 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 Section 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.
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. Effecting such a division may be tried, but it is unclear whether the IRS or the courts will uphold it.
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 an individual and come out as a corporation, partnership, trust, estate or other separate entity.