Partnership Split Case Study: Two Partners Wanted Different Things

This case study is illustrative. Names, figures, and details are composite examples based on common investor scenarios. Consult a qualified tax professional for advice specific to your situation.

Two Partners, One Property, Different Goals

Michael and Steve had been friends since college. Fifteen years ago, they formed an LLC and purchased a 35,000-square-foot industrial warehouse for $1.2 million, splitting ownership 50/50. The property was fully leased to a single tenant on a long-term net lease, generating steady cash flow with minimal management demands. It was, by most measures, the easiest investment either of them had ever made.

By early 2025, the warehouse was appraised at $2.4 million. Each partner's equity was worth approximately $1.2 million.

Then the conversation that many partnerships eventually have took place. Michael's health had changed. He wanted to retire, spend time with his grandchildren, and simplify his financial life. He wanted out of real estate entirely — not into a different property, but out.

Steve, still active at 65, had no interest in stopping. He wanted to continue investing, defer his taxes, and grow his portfolio.

Over coffee one evening, they laid it out plainly: Michael wanted cash. Steve wanted a 1031 exchange. And they owned the property together through a single LLC.

Why the LLC Created a Problem

Their accountant explained the core issue: under IRC Section 1031, the "same taxpayer" rule requires that the entity that sells the property must be the same entity that acquires the replacement property. If the LLC sold the warehouse, the LLC — not Michael, not Steve — would need to complete the exchange.

This created three possible paths, and two of them did not work.

Option 1: The LLC Sells and Exchanges

The LLC could sell the warehouse and reinvest in another property through a 1031 exchange. The problem: Michael did not want another property. He wanted cash. If the LLC exchanged, Michael would still be an owner of a real estate LLC — exactly what he was trying to leave. Distributing cash to Michael from the LLC after an exchange would likely be treated as a taxable event, defeating the purpose.

Why they rejected it: It solved Steve's problem but trapped Michael.

Option 2: The LLC Sells, Partners Split the Decision

Michael takes his share as cash, Steve exchanges his share. The problem: the LLC is a single taxpayer. It either exchanges or it does not. The IRS does not allow one member of an LLC to exchange while another takes cash from the same entity sale. The "same taxpayer" rule does not bend for individual members.

Why they rejected it: It is not legally possible under 1031 rules.

Option 3: Restructure the Ownership Before the Sale

Michael and Steve could dissolve the LLC and convert to a tenants-in-common (TIC) arrangement, where each owns 50% of the physical property directly — not through an entity. As separate TIC owners, each makes an independent decision at sale. Michael sells his 50% and takes cash. Steve sells his 50% and exchanges.

Why they chose it: It was the only path that respected both partners' goals.

The Restructuring: Why Timing Was Everything

Their tax attorney agreed that TIC conversion was the right approach — but delivered a critical warning. The IRS scrutinizes entity restructurings that happen close in time to a property sale. If Michael and Steve dissolved the LLC the week before listing the property, the IRS could argue the restructuring had no legitimate business purpose beyond tax avoidance. In that scenario, the IRS might recharacterize the entire transaction as a single-entity sale, forcing both partners into the same 1031 decision. That would have been disastrous.

The attorney recommended restructuring at least 18 months before any planned sale. The time gap would establish that the conversion was driven by the partners' genuinely diverging long-term goals — not by an imminent transaction.

January 2024: The Conversion

The attorney drafted the deed transfer converting the LLC's ownership into a TIC structure. The property was no longer held by the LLC. Michael owned 50% of the warehouse directly. Steve owned 50% directly. The deed was recorded in the county records in February 2024.

The conversion itself was a non-taxable event — the partners were changing the form of ownership, not selling or exchanging anything.

February 2024 through August 2025: Operating as TIC Owners

For 18 months, Michael and Steve operated as co-owners under the TIC structure. They collected rent together, shared expenses, and managed the property jointly. This period of genuine TIC operation was critical — it demonstrated to any potential IRS examiner that the restructuring was a real change in their business relationship, not a transient arrangement created for a single transaction.

August 2025: The Tenant Decision

The warehouse tenant decided not to renew the lease and vacated. Michael and Steve faced a choice: renovate and re-lease, or sell. Given their divergent goals — Michael wanted out, Steve wanted to exchange — selling was the clear path.

October 2025 through March 2026: The Sale

They listed the property as a single asset but structured the transaction to close with two separate TIC sellers. They found a buyer willing to purchase the entire warehouse from both TIC owners simultaneously.

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

The Closing: Two Paths from One Property

On closing day, the proceeds were split and handled separately.

Michael's Path: Cash Out

• Michael's 50% share of net proceeds: approximately $1.1 million
• His adjusted cost basis in his 50%: approximately $600,000
• His capital gain: approximately $500,000
• Michael took the cash. He paid capital gains tax — roughly $150,000 in combined federal, state, and NIIT taxes — and walked away.
• He used the after-tax proceeds to buy a retirement condo in a warm climate. No exchange, no ongoing real estate investment obligations. Clean exit.

Steve's Path: 1031 Exchange into a DST

• Steve's 50% share of net proceeds: approximately $1.1 million
• His adjusted cost basis in his 50%: approximately $600,000
• His capital gain: approximately $500,000
• Instead of taking cash, Steve's proceeds went directly to his qualified intermediary (QI). The QI held the funds while Steve identified replacement property.
• Steve chose a Delaware Statutory Trust (DST) invested in a diversified portfolio of commercial properties. The DST allowed him to remain invested in real estate, receive monthly income distributions, and defer the approximately $150,000 in taxes he would have owed.
• By deferring, Steve invested the full $1.1 million rather than the $950,000 he would have had after taxes. That additional $150,000, compounding inside the DST over a 7-to-10-year hold period, has meaningful long-term value.

What Made This Work

Legitimate Business Purpose

The 18-month gap between restructuring and sale was the foundation. The IRS evaluates whether a restructuring has economic substance independent of tax benefits. Michael and Steve's diverging life plans — retirement versus continued investing — provided genuine non-tax reasons for dissolving the LLC. The time gap reinforced that the restructuring was not a transaction-driven maneuver.

Clean Documentation

The deed transfer was recorded. The TIC operating period was documented through shared expense records, rent collection, and property management correspondence. If an auditor ever examined the transaction, the paper trail supported the legitimacy of the restructuring from start to finish.

Coordinated but Separate Closings

The closing was structured so that each TIC owner's proceeds were handled independently. Michael's funds went to him. Steve's funds went to his QI. The title company, the buyer's attorney, and both partners' counsel coordinated to ensure the separation was clean.

Professional Guidance from the Start

Michael and Steve engaged a real estate tax attorney — not just their accountant — before making any decisions. The attorney identified the same-taxpayer issue, recommended the TIC restructuring, and set the timeline. Without that early guidance, they might have waited until the sale was imminent and lost the ability to restructure safely.

What Could Have Gone Wrong

Restructuring Too Late

If they had dissolved the LLC a week before listing the property, the IRS could have challenged the restructuring as lacking business purpose and recharacterized it as a single-entity sale. Michael would have been forced into an exchange he did not want, or Steve would have been forced to pay taxes he intended to defer.

Using the LLC to Split Outcomes

They might have attempted to have the LLC sell, exchange part of the proceeds, and distribute different amounts to each partner. This approach creates layers of tax complexity. An LLC-level exchange followed by a distribution to Michael could trigger recognition of gain at the distribution stage, and the IRS would scrutinize whether the LLC genuinely intended to hold the replacement property for investment or was merely acting as a conduit.

Failing to Coordinate with the QI

If Steve's QI had not been engaged before closing, the proceeds might have gone directly to Steve rather than to the QI — which would have disqualified the exchange. Constructive receipt of funds before the QI is in place is a common and avoidable error.

Delaying the Conversation

If Michael had not raised his retirement plans until the lease was expiring, there would have been no time to restructure. They would have been stuck with the LLC and forced to negotiate an imperfect solution under time pressure.

Lessons for Partners in Similar Situations

1. Have the conversation early. If you are in a partnership or LLC and you suspect that partners may eventually want different outcomes — one wants to sell, another wants to exchange, a third wants to hold — discuss it now. Do not wait until a sale is on the table.

2. Restructure well in advance. If TIC conversion or another restructuring is needed, do it 18 or more months before any contemplated sale. The time gap is your strongest defense against an IRS challenge.

3. Engage a tax attorney, not just an accountant. Entity restructuring and 1031 compliance involve legal analysis that goes beyond tax return preparation. A tax attorney can identify risks your accountant may not flag.

4. Coordinate all professionals early. Your tax attorney, CPA, QI, and real estate broker should all understand the structure and the timeline. Miscoordination between any of them can jeopardize the outcome.

5. Document everything. The restructuring, the operating period, the separate closings — document each step. If the IRS ever examines the transaction, your documentation is your evidence.

The Outcome

Michael retired with a clean exit and enough after-tax proceeds to fund the next chapter of his life. Steve deferred $150,000 in taxes, invested the full $1.1 million into a DST, and continued building his real estate portfolio without management responsibilities.

Neither partner compromised on what mattered to them. The restructuring took forethought and patience — but it allowed a single property to serve two fundamentally different goals.

If you are considering a similar structure, talk to an advisor with experience in partnership restructuring and 1031 exchanges. For more on entity structures, see 1031 exchanges with LLCs and partnerships.