Norman Lencz, Brian Masterson, and Chris Davidson published "Partnership Like-Kind Exchanges: What to Do When Someone Wants to Cash Out" in the September – October 2017 edition of the Journal of Passthrough Entities.
Here's an excerpt:
As the real estate market continues to improve since the "crash" in 2006–2007, more and more taxpayers find themselves with appreciated real estate that they would like to unload, and they may desire to roll their sale proceeds into new real estate in a tax-deferred, like-kind exchange under Code Sec. 1031. Oftentimes, the real estate to be sold is held through a partnership (or limited liability company taxed as a partnership), which generally does not present any issues for engaging in a tax-free, like-kind exchange, provided that the exchange is undertaken by the partnership, not the partners. But, if some partners want to engage in a like-kind exchange and some want to "cash out" their investment, problems can arise. Consider the following example:
Adam, Beth, and Chris are equal partners in ABC, LLC, which owns a building with a fair market value of $15 million and a basis of $6 million. Each of Adam, Beth and Chris have a basis of $2 million in their one-third interest in ABC, LLC. All of the members want to sell the building, but Adam wants to "cash out," while Beth and Chris want to defer their taxable gain by acquiring like-kind property in a Code Sec. 1031 like-kind exchange. If ABC, LLC sells the building for $15 million, "rolls over" $10 million of the proceeds into like-kind replacement property (through a "qualified intermediary") and distributes the remaining $5 million in cash to Adam, ABC, LLC would recognize $5 million of gain on the transaction (i.e., gain is recognized to the extent of the cash boot). This gain would then flow through equally to each of Adam, Beth, and Chris. Thus, Beth and Chris would each recognize $1.67 million of gain, even though they rolled over all of their share of the cash proceeds—clearly an undesirable result. Moreover, Adam will still recognize the full $3 million of gain inherent in his interest (i.e., $1.67 million of gain on the sale and an additional $1.33 million of gain under Code Sec. 731(a) on the distribution of the $5 million of cash).
As Beth and Chris obviously will not be thrilled with recognizing gain when they have not cashed out any sale proceeds, is there anything that can be done to achieve a more favorable tax result?