Partnership Split Case Study: Two Partners Wanted Different Things

The Setup: A Successful Partnership Ends

Michael and Steve had been friends since college. Fifteen years ago, they formed an LLC and purchased a 35,000-square-foot industrial warehouse together. Each owned 50%. The property was fully leased to a single tenant on a long-term lease, generating steady cash flow.

Over the years, the property had appreciated significantly. They'd bought it for $1.2 million. In early 2025, it was appraised at $2.4 million. Each partner's equity was worth $1.2 million (50% of $2.4 million).

Then life happened. Michael's health changed. He wanted to retire, cash out, and spend more time with his grandchildren. Steve, still energetic at 65, wanted to continue investing in real estate and grow his portfolio.

They sat down one evening over coffee, and Steve said: "What if you cash out and I keep investing?"

Michael nodded. "That's what I want. But how do we do it? If we sell the warehouse, we both get taxed on the gain."

The Problem: The "Same Taxpayer" Rule

Michael and Steve's accountant explained the situation:

Under IRC Section 1031, the "same taxpayer" rule requires that the person (or entity) that sells is the person (or entity) that must do the exchange. If the LLC sells the property, the LLC must exchange. The LLC cannot sell and then distribute proceeds to Michael and Steve individually; that distribution itself could be taxable.

Scenario 1: The LLC sells and exchanges.

• The LLC exchanges into another property.
• Michael, having cashed out his share, receives either a cash distribution (taxable to him) or a property distribution.
• This doesn't work well because Michael wants to be out of real estate, and Steve wants to keep investing alone.

Scenario 2: The LLC sells, Michael takes his share in cash, Steve exchanges his share.

• This won't work because the LLC is a single entity. The LLC either exchanges or doesn't; Michael and Steve can't split the decision.

Scenario 3: Restructure into separate ownership.

• Michael and Steve could restructure the LLC into a tenants-in-common arrangement, where Michael owns 50% of the physical property directly and Steve owns 50% directly.
• Michael sells his 50% and takes the proceeds without exchanging.
• Steve sells his 50% and exchanges into a replacement property (or uses a DST or other structure).
• Each makes their own 1031 decision independently.

The accountant recommended Scenario 3, but cautioned: "This restructuring has to happen well in advance. If the IRS sees you restructuring the day before the sale, they'll challenge it as a tax-avoidance scheme."

The Solution: Restructure into TIC 18 Months in Advance

Michael and Steve decided to restructure. Here's how they did it:

January 2024 (18 months before planned sale): Michael and Steve consulted a real estate tax attorney. The attorney explained that converting the LLC into a tenants-in-common structure would mean:

• The property would no longer be held in the LLC.
• Michael would own 50% of the physical property directly.
• Steve would own 50% of the physical property directly.
• Each could make independent decisions about their share.
• The conversion itself would be a non-taxable event (since they were just changing the ownership form, not selling).

The attorney drafted the deed transfer, converting the LLC ownership to TIC ownership. The deed was recorded in the county records in February 2024.

Why 18 months in advance? The IRS is skeptical of restructuring that happens near the time of a sale. If they'd restructured in October 2025 (just before the planned 2026 sale), the IRS might have argued the restructuring was a tax-motivated maneuver with no legitimate business purpose. By restructuring 18 months earlier, Michael and Steve could demonstrate that the restructuring was a genuine change in their partnership structure, driven by their different long-term goals.

February 2024 - August 2025: Michael and Steve operated as TIC owners for roughly 18 months. They managed the property together, collected rent, paid expenses, and operated as co-owners. This further established that the TIC structure was legitimate and not a last-minute tax-avoidance move.

August 2025: The single tenant decided not to renew and vacated. Michael and Steve had to decide: renovate and re-lease, or sell. They decided to sell and let the proceeds determine their next moves.

October 2025 - March 2026: Michael and Steve listed the property separately as two 50% interests.

Wait, actually, let me correct this: they listed the property as a whole (one property for sale), but marketed to buyers who could close with two TIC owners. They eventually found a buyer willing to close with both TIC owners simultaneously.

The sale closed in March 2026. The sale price was $2.4 million. Gross proceeds were $2.4 million. After broker commissions (6%) and closing costs, net proceeds were approximately $2.2 million.

The Bifurcated Closing: Each Owner's Separate Path

On the day of closing, an interesting thing happened:

Michael's side:

• Michael's 50% share sold for $1.2 million (his share of the net proceeds).
• Michael's basis in his 50% was approximately $600,000.
• Michael's capital gain was approximately $600,000.
• Michael took his $1.2 million in cash. He paid capital gains tax on his $600,000 gain (roughly $180,000 in federal + state + NIIT taxes).
• Michael cashed out and retired. Done.

Steve's side:

• Steve's 50% share sold for $1.2 million (his share of the net proceeds).
• Steve's basis in his 50% was approximately $600,000.
• Steve's capital gain was approximately $600,000.
• Instead of taking cash, Steve immediately initiated a 1031 exchange through his QI.
• Steve identified a Delaware Statutory Trust (DST) as his replacement property.
• Steve's QI funded the DST acquisition, and Steve exchanged into a diversified portfolio of commercial properties (via the DST structure).
• Steve deferred taxes on his $600,000 in gain.

The key: because Michael and Steve were separate TIC owners, each could make an independent 1031 decision. Michael opted out. Steve opted in.

The Numbers: What They Each Achieved

Michael:

• Sale proceeds: $1.2 million
• Taxes owed: approximately $180,000
• After-tax proceeds: approximately $1.02 million
• Next step: He used the $1.02 million to purchase a condo in a warm climate for retirement living. No exchange, because he wasn't reinvesting in real estate.

Steve:

• Sale proceeds: $1.2 million
• Taxes deferred: approximately $180,000 (via 1031 exchange)
• DST acquisition: $1.2 million (all from QI-held proceeds)
• Tax deferred allows him to reinvest the full $1.2 million instead of $1.02 million.
• Additional capital available due to deferral: approximately $180,000

The 1031 exchange was worth about $180,000 to Steve in deferred taxes, which allowed him to invest a larger amount in the DST.

What Went Right: The Importance of Advance Planning

Legitimate business purpose: By restructuring 18 months in advance, Michael and Steve established that the restructuring wasn't a tax-avoidance scheme. It was a genuine change in their partnership structure driven by their diverging long-term goals.

IRS comfort: The IRS is much more comfortable with restructurings that happen well before a sale. If an auditor ever examined Michael and Steve's transaction, the timeline would support the legitimacy of the restructuring.

Clean separation: Because they were separate TIC owners from February 2024 through the sale in March 2026, there was no question about who owned what or whether the restructuring was related to the sale.

Execution: The closing was structured cleanly. Michael and Steve's attorneys coordinated with the buyer and the title company to ensure each TIC owner's proceeds were held separately and that each could make independent 1031 decisions.

What Could Have Gone Wrong (And Lessons from It)

If they'd restructured a week before the sale: The IRS would likely have scrutinized the restructuring as a tax-avoidance maneuver with no legitimate business purpose. They might have recharacterized the transaction as a single entity sale, forcing Michael and Steve to either both exchange or both pay taxes. This would have been disastrous for Michael (who wanted to cash out) and for Steve (who wanted to exchange).

If they'd tried to use the LLC entity to split outcomes: Michael and Steve might have attempted to have the LLC sell, exchange the proceeds into a property, and then distribute different amounts to Michael and Steve. This is messy and creates additional tax questions. The TIC structure was cleaner.

If they'd delayed the restructuring discussion: If Michael had only mentioned his retirement plans the week before the sale, there would be no time to restructure and no time to establish the legitimate business purpose. They would have been stuck with the LLC structure and forced to make a unified 1031 decision.

Lessons for Partners Considering Similar Structures

1. Have the conversation early. If you're in a partnership or LLC and you think you might have different long-term goals (one partner wants to cash out, another wants to keep investing), discuss it early. Don't wait until a sale is imminent.

2. Restructure well in advance. If you decide to restructure, do it 18+ months before any planned sale. This establishes legitimate business purpose and reduces IRS risk.

3. Consult a tax attorney, not just an accountant. Tax attorneys specialize in entity restructuring and can advise on the specific risks and best practices. This is not a DIY decision.

4. Coordinate with your QI early. Once you've restructured and you know you'll be exchanging, inform your QI of the timeline and the structure. If you're using multiple QIs (one for Michael's non-exchange sale, one for Steve's exchange), make sure they're coordinated.

5. Plan the closing carefully. Work with your real estate attorney and the buyer's attorney to ensure the closing is structured to separate Michael and Steve's proceeds appropriately and to allow each to pursue their own 1031 path.

Would Michael and Steve Do It Again?

Michael says: "Absolutely. The restructuring let me cash out clean and pursue my retirement without being entangled in Steve's continued real estate ventures. And the advance planning meant there were no tax surprises."

Steve says: "The restructuring was the key to my 1031 exchange. Without it, I would have had to either stay in the LLC or negotiate a complex distribution. Instead, I got a clean exit through the DST, and my $1.2 million is now invested in a diversified property portfolio with full tax deferral."

The Bottom Line

If you're in a partnership or LLC and partners have different long-term goals (one wants to cash out, another wants to exchange), restructuring into separate ownership (such as tenants-in-common) can allow each partner to pursue their own 1031 path.

The critical lesson: do the restructuring well in advance, 18+ months before any planned sale. This establishes legitimate business purpose and minimizes IRS risk.

If you're considering this structure, talk to an advisor or tax attorney with experience in partnership restructuring and 1031 exchanges. The upfront planning investment pays off in clean execution and tax certainty.

For more on entity structures and 1031 exchanges, see 1031 exchanges with LLCs and partnerships and drop-and-swap structures.