Buying Out Your Partner: How Acquiring an LLC Interest Can Qualify as Replacement Property in a 1031 Exchange
We spoke recently with a gentleman who is planning a 1031 exchange, and his situation is a perfect illustration of one of the most counterintuitive — and most useful — rules in this field.
He owns two pieces of raw land. The first he owns outright, free of any debt, worth roughly $1.7 million. The second is also raw land, worth about $870,000, but it is not held in his own name. It is owned by a limited liability company taxed as a partnership, in which he and one other person each hold a 50% membership interest. There is no debt on either property. Neither is listed for sale, and there is no purchase and sale agreement on either one.
His co-owner does not want to do an exchange. She simply wants to cash out — to receive money for her share and move on. He, on the other hand, wants to defer as much tax as possible.
At first glance this looks like a problem, because of a rule that surprises almost everyone: you cannot do a 1031 exchange of a partnership interest. But there is an elegant path through it. This article explains why a membership interest normally cannot be exchanged, and how — under a specific IRS ruling — buying out a co-owner can nonetheless qualify as replacement property in the buyer's own exchange.
The Rule That Trips Everyone Up: Partnership Interests Do Not Qualify
Section 1031 applies only to real property held for productive use in a trade or business or for investment. A membership interest in an LLC taxed as a partnership is not real property — it is an interest in an entity. For most of the statute's history, IRC §1031(a)(2)(D) expressly excluded “interests in a partnership” from like-kind exchange treatment. After the 2017 Tax Cuts and Jobs Act limited §1031 to real property, the express exclusion became unnecessary — a partnership interest simply is not real property, so it cannot be exchanged.
This is why the LLC structure, which is wonderful for liability and operational purposes, creates a wrinkle for exchange planning. The land inside the LLC is real property. But what each owner holds is an interest in a tax partnership — and that is the thing the tax code will not let you exchange.
So if our caller's LLC simply sold the land and distributed the cash, and he then tried to roll his share into an exchange, he would have a problem: the gain would flow through the partnership, and his attempt to exchange would run straight into the partnership-interest barrier. Worse, his co-owner wants cash, so the two owners have genuinely different goals. This is the classic situation where partners' objectives diverge — one wants to defer, the other wants to be paid.
The Elegant Move: Buy Her Out as Replacement Property
Here is where it gets interesting. Instead of having the LLC sell the land, he can use the proceeds from selling his $1.7 million parcel to buy out his co-owner's 50% interest — and that buyout can itself qualify as replacement property in his exchange.
That sounds impossible given the rule we just covered. How can acquiring a membership interest count as acquiring real property? The answer is Revenue Ruling 99-6.
Rev. Rul. 99-6 addresses exactly what happens when a multi-member LLC taxed as a partnership becomes a single-member LLC because one member buys out the other. The moment our caller acquires his co-owner's remaining 50%, he owns 100%. A single-member LLC is, by default, a disregarded entity for federal tax purposes — the IRS looks straight through it to the owner. And the ruling tells us precisely how to characterize the transaction, with a deliberately asymmetric result:
- For the seller (the co-owner cashing out): She is treated as selling a partnership interest under §741. That is an ordinary taxable disposition. It does not qualify for §1031 — which is exactly fine, because she wants cash, not a deferral.
- For the buyer (our caller): The partnership is deemed to make a liquidating distribution of its assets, and he is then treated as purchasing the underlying real property that was distributed to the departing member. He is not treated as buying an entity interest — he is treated as acquiring real estate.
Because the buyer is deemed to acquire real property, that acquisition can serve as replacement property in his 1031 exchange, keeping the gain fully tax-deferred. He sells the $1.7 million parcel, the proceeds go to the qualified intermediary, and the QI funds the buyout of his co-owner's interest — which, for him, is treated as the purchase of like-kind real estate. The IRS reinforced this same disregarded-entity reasoning in PLR 200807005, where a taxpayer who acquired 100% of a partnership holding real property was treated as having acquired the underlying real property for §1031 purposes.
The same transaction, two completely different tax characters. She sells a partnership interest and pays her tax. He acquires real property and defers his. One document, opposite outcomes — and both parties get exactly what they want.
Why It Only Works in One Direction
It is worth pausing on why the rule is asymmetric, because it is the heart of the strategy. The selling member never ends up owning the underlying real estate — she goes from holding an entity interest to holding cash, so from her side there is nothing real-property-like to exchange. The buying member, by contrast, ends up holding the real estate directly (through a now-disregarded LLC), so from his side the economic substance genuinely is an acquisition of real property. Rev. Rul. 99-6 simply matches the tax treatment to that economic reality on each side.
This is also why the LLC interest could never have worked as relinquished property for her in an exchange — and why so many investors are caught off guard. The character of the transaction depends on which side of it you are standing on.
Putting It Together for Our Caller
Here is the shape of the plan we discussed:
- The $1.7 million parcel he owns outright becomes the relinquished property. When a buyer materializes, the sale proceeds go to a qualified intermediary — he never touches them — preserving the exchange.
- Within the exchange, the QI uses those proceeds to acquire his co-owner's 50% LLC interest. Under Rev. Rul. 99-6, that buyout is treated as his purchase of the underlying real property, qualifying as replacement property. He now owns 100% of the LLC, which becomes a disregarded entity — so for tax purposes he simply owns the $870,000 parcel directly.
- He still needs to acquire additional replacement property. This is essential, not optional. The buyout alone is not nearly enough: he already owns his own 50%, so what he is acquiring in the exchange is only his co-owner's 50% interest — roughly $435,000 of value out of the $870,000 parcel. Against the $1.7 million he is relinquishing, the buyout by itself would leave well over $1.2 million of unspent exchange proceeds exposed to tax. To achieve full deferral he must identify and acquire additional like-kind real property to absorb the remaining proceeds, all within the 45-day identification and 180-day completion windows.
- His co-owner receives cash for her interest, reports it as a sale of a partnership interest, and is done — precisely the clean exit she wanted.
The beauty of it is that one structure satisfies two people with opposite goals, defers his gain, and consolidates the land under his sole ownership.
The Cautions — Because the Details Decide Everything
This is sophisticated planning, and it has to be executed correctly:
- Sequence and documentation matter. The buyout has to be structured and papered as part of the exchange, with the qualified intermediary in the chain, not as a side deal he funds personally.
- Hot assets (§751). On the seller's side, depreciation recapture and other "hot asset" items can change her tax picture. In this particular case there was no depreciation recapture, because the LLC's only asset was raw land, which is not depreciable — but that is a fact specific to this deal. Where a partnership holds buildings, equipment, or other depreciable or "hot" assets, the recapture analysis can be significant, and it must be determined on a case-by-case basis by the selling member's own advisor.
- He must acquire enough total replacement value. As noted above, buying out his co-owner's 50% interest gives him only about $435,000 of replacement value — nowhere near the $1.7 million he is relinquishing. To fully defer, he must acquire replacement property of equal or greater value and reinvest all of his equity — which means at least one additional replacement property is required here, not merely advisable.
- Hold for investment. Both his relinquished parcel and the replacement real estate must be genuinely held for investment.
- Coordinate every advisor. His CPA, his attorney, his co-owner's advisor, and the qualified intermediary all need to be reading from the same script.
None of this is do-it-yourself territory. It is exactly the kind of structuring that should be set up before anything is listed or signed — which, again, is why the timing of this particular conversation is so favorable.
A Washington Note
For owners here in the Puget Sound region, there is a state-level bright spot. Under Washington's capital gains tax, gains from the sale of real property are excluded (ESSB 6346 §302). So for a Tacoma or Pierce County investor, the planning above addresses the federal exposure without a competing state tax on the real estate gain itself.
The Takeaway
A partnership interest cannot be exchanged — but that is not the end of the story. When co-owners want to go in different directions, the tax code, through Revenue Ruling 99-6, offers a remarkable result: the person buying out the other can be treated as acquiring the underlying real property, turning a partner buyout into qualifying replacement property in a 1031 exchange. The partner who wants cash gets cash. The partner who wants to defer gets his deferral. And it all hinges on understanding that the same transaction can have two entirely different tax identities depending on which side you are on.
If you own property through an LLC or partnership and you are thinking about selling — or you and a co-owner want different things — the single most valuable thing you can do is talk to a qualified intermediary before there is a buyer, a listing, or a signed agreement. The planning window is widest when nothing has happened yet. Once a deal is on the table, your options narrow quickly.
Jeff Helsdon, CES® Certified Exchange Specialist since 2003
Disclaimer: This article is for informational purposes only and does not constitute legal, tax, or financial advice. Revenue Ruling 99-6, partnership “hot asset” rules, and the “held for investment” requirement all turn on specific facts and timing. Consult your own attorney, CPA, and financial advisor before structuring any exchange involving a partnership or LLC interest.
