1031 Exchange Considerations for Real Estate Funds: Structuring Dispositions to Defer LP-Level Taxes

When a real estate fund prepares to sell a property, the tax implications at the LP level often complicate what might otherwise be a straightforward disposition. Under IRC Section 1031, individual investors can defer capital gains by exchanging one investment property for another, but partnership interests are explicitly excluded from like-kind exchange treatment. This creates structural challenges when some LPs want to defer taxes while others prefer to take cash.

Why Can't LPs Simply Exchange Their Partnership Interest?

The IRS treats partnership interests as personal property, not real estate. Even if a fund owns nothing but real property, an LP's interest in that fund remains ineligible for 1031 treatment. This distinction becomes critical at exit: partners receive cash distributions from the partnership upon sale, not a direct interest in real property that could flow into a replacement asset.

Funds typically consult tax counsel well in advance of any disposition to evaluate structuring options for LPs with diverging objectives.

What Structuring Options Exist at the Fund Level?

Several approaches can accommodate LP-level tax deferral, though each carries complexity:

• Fund-level exchange: The partnership itself executes the 1031 exchange, selling the relinquished property and acquiring replacement property within the 45-day identification and 180-day closing windows. All LPs remain invested in the new asset.

• Drop and swap: Before the sale, the fund distributes tenancy-in-common (TIC) interests directly to individual LPs who wish to pursue their own exchanges. Those LPs then sell their TIC interests and complete separate 1031 transactions. Timing matters, distributions occurring too close to sale may invite IRS scrutiny.

• Installment note redemption: The fund sells for a combination of cash and an installment note. Exiting LPs receive the note as redemption for their interests, while remaining LPs use the cash portion to complete a fund-level exchange.

• Partnership division under IRC 708(b)(2): The fund divides into two partnerships, one that proceeds with the 1031 exchange and another that distributes cash to exiting partners. If the continuing partnership maintains more than 50% of the original ownership, it retains the original entity's tax attributes.

How Do Delaware Statutory Trusts Factor In?

For LPs seeking a passive replacement property option, Delaware Statutory Trusts (DSTs) have become increasingly common. IRS Revenue Ruling 2004-86 confirms that beneficial interests in a properly structured DST qualify as like-kind real property for 1031 purposes.

DSTs offer several practical advantages:

• Faster closings than traditional acquisitions, often completing within days rather than weeks, helpful given the 180-day deadline

• Access to institutional-quality properties without active management obligations

• Fractional ownership that can match exact exchange amounts

However, DSTs come with restrictions on capital contributions, borrowing, and operational changes. They also require accredited investor status and typically lock capital for 5-10 years.

What Should Operations Teams Track?

Coordination between fund accounting, investor relations, and tax advisors becomes essential when dispositions involve mixed LP objectives. Documentation requirements include verifying qualified intermediary engagement, monitoring identification and closing deadlines, and ensuring proper allocation of any taxable gain to LPs who elect cash.

Establishing clear policies around LP communication, ideally well before a property is marketed, reduces friction when LPs have limited windows to make deferral elections. Funds that anticipate these conversations early tend to execute smoother exits while preserving LP flexibility.