March 24, 2023
By: Julia Mastrotto, Esq., Counsel
Internal Revenue Code Section 1031 solely applies to the exchange of real property, as personal property exchanges are no longer eligible. Many exchangers acquire a tenancy in common (TIC) interest, a coownership arrangement that allows two or more parties, or tenants in common, to share fractional ownership interest in real property and qualify for an exchange. However, fractional interests in business entities or partnership interests do not qualify as like kind property for purposes of a 1031 exchange. Treas. Reg. § 1.1031(a)-3(a)(5)(i) specifically states that “interests in a partnership” are “not real property for purposes of section 1031.” In general, tax law categorizes interests in entities taxed as partnerships, shares in corporations, and REIT units, as personal property.
In essence, this article will illustrate the distinction between ownership of a fractional interest in “real estate” for 1031 exchange purposes, versus buying equity in a business (a partnership interest) that does not meet the 1031 requirement to qualify as replacement property.
In 2022 the United States Court of Appeals for the 2nd Circuit affirmed a 2020 decision of the U.S. Tax Court in the case Gluck v. Commissioner. The Glucks, taxpayers who attempted to transact a 1031 exchange in 2012, filed tax returns indicating that their interest in the replacement property was like-kind real property to their relinquished condominium for purposes of completing a 1031 tax-deferred exchange. However, the Tax Court had determined that the Glucks did not purchase an interest in the real estate itself, but rather an interest in the PARTNERSHIP that owned the real estate. The partnership that owned the real estate filed a Form 1065 Partnership return, and distributed K-1s to the Glucks and other partners which included income and tax items from the partnership’s operation of the rental real estate. This ultimate determination by the Court was based upon the partnership’s tax return filed that same year which stated that the partnership owned the property and the taxpayers had purchased only an interest in the partnership. The reporting showed the Glucks’ new interest in the partnership matched the value of the replacement property that the Glucks claimed they received in the 1031 exchange. Moreover, it demonstrated that the Seller of the interest was no longer part of the 13-member partnership and had been replaced by the Glucks.
“Additionally, the Schedule K-1 detailed, among other items, Gluck LLC’s share of the Partnership’s “rental real estate income” and its depreciation from “rental real estate.” . . . the Schedule K-1 also identified Gluck LLC’s share of the Partnership’s profit, losses, and capital as 0% at the beginning of the 2012 tax year, and as 50% at the end of the 2012 tax year—matching the share of the Property that the Glucks contend that Gluck LLC acquired in 2012.”
The Glucks argued in defense that they were unaware that the interest they purchased was a partnership interest, however, the Court determined that they were on notice of the manner in which the partnership reported the ownership. The Glucks had received K-1s and continued to receive notice of the partnership’s tax returns, which on their face stated that they purchased only a business interest. The Glucks made no effort to reconcile this supposed error by contesting the partnership’s tax reporting.
“On audit, the IRS found that the Glucks’ tax return was inconsistent with G&P’s partnership return and disallowed the Glucks’ claimed like-kind exchange, resulting in an increased tax liability for the Glucks of more than $1.5 million.”
The situation in Gluck is unfortunate in that it identifies the need to engage in additional due diligence to confirm that a partnership tax return is not being filed even though the legal title may reflect a tenancy in common (TIC), which, if handled properly, is eligible for a 1031 exchange. Although the court documents provide limited background, it appears that title to the real estate was originally conveyed as individual TIC interests along with an ownership agreement to manage the property between the individual owners; however, over the course of time, the treatment of that ownership relationship changed and began to look more like a tax partnership. It is essential that an investor does not rely on legal title alone when exchanging out of or into an interest that has been presented to them as a qualifying TIC interest. They should confirm with the seller and their tax advisors that no Form 1065 is being filed, and if it is not, then the taxpayer should evaluate the potential to adjust the tax reporting prior to executing the exchange.
Revenue Procedure 2002-22 addresses potential considerations for fractional ownership interests in real property as qualifying as replacement property in a 1031 exchange as opposed to being considered an interest in a partnership. It does not carry the same weight as a ruling or even a safe harbor, but instead provides guidelines for taxpayers and their advisors to follow when setting up tenancy in common arrangements.
As aforementioned, interests in a partnership are not real property for purposes of section 1031 and will not qualify as like-kind property for purposes of 1031 tax-deferral. It should be noted that there is one exception to this rule (see footnote five). To protect oneself from increased tax liability, it is critical that a taxpayer consult with their tax or legal advisors and conduct their own due diligence prior to initiating a 1031 exchange.
 §1.1031(a)-3 Definition of real property. The term real property under section 1031 and § 1.1031(a)-1 through 1.1031(k)-1 means land and improvements to land, unsevered natural products of land, and water and air space superjacent to land. Under paragraph (a)(5) of this section, an intangible interest in real property of a type described in this paragraph (a)(1) is real property for purposes of section 1031 and this section. Property that is real property under State or local law as provided in paragraph (a)(6) of this section is real property for purposes of section 1031 and this section.
 Section 301.7701-2(a) provides that a business entity is any entity recognized for federal tax purposes (including an entity with a single owner that may be disregarded as an entity separate from its owner under 301.7701-3) that is not properly classified as a trust under 301.7701-4 or otherwise subject to special treatment under the Internal Revenue Code. Rev. Prov. 2002-22.
 Gluck v. Commissioner, No. 21-867, 2022 U.S. App. LEXIS 6913, at *10 (2d Cir. Mar. 17, 2022).
 Id. at *2-3 (2d Cir. Mar. 17, 2022).
 It should be noted that there is one exception to the partnership interest rule discussed in this article. PLR-123308-07 details an instance in which a taxpayer may qualify a partnership interest as replacement property, but only if the taxpayer acquires all of the outstanding partnership interests through the exchange. “Taxpayer will acquire 100 percent of the partners’ interests in Partnership. Pursuant to Rev. Rul. 99-6, Partnership is considered to have terminated under § 708(b)(1)(A) and made a liquidating distribution of its real property assets to its partners, and Taxpayer is treated as having acquired such real property assets from the partners for federal tax purposes. Since Taxpayer will acquire 100 percent of the partners’ interests in Partnership, Taxpayer is treated as having acquired the real property assets of Partnership rather than as having acquired partnership interests from the partners . . . We view this transaction as a like-kind exchange under § 1031(a)(1), rather than as an exchange of partnership interests in violation of § 1031(a)(2)(D).” PLR-123308-07.
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