Partnership Installment Note (PIN) Method: How to Complete a 1031 Exchange When an LLC Partner Wants to Exit

When members of a multi-member LLC disagree on whether to cash out or pursue a like-kind exchange, the Partnership Installment Note (PIN) method offers a solution, allowing the entity to remain intact and preserving Section 1031 tax deferral even as one partner exits.

When three or more individuals own an investment property through a partnership or multi-member LLC, a common problem arises when it comes time to sell: some members want to cash out, paying capital gains taxes and ending the partnership, while others want to continue the partnership and perform a 1031 like-kind exchange into a new property, utilizing IRC Section 1031 to defer taxes and reinvest the full sales proceeds.

This presents a problem because it is not possible to exchange only your share of a jointly-owned property, meaning tax deferral is only allowed if the partnership stays together and all members agree to pursue a like-kind exchange. If any one member of an LLC elects to cash out, the 1031 exchange will violate the same taxpayer rule and will be deemed invalid.

While at first glance, this issue may seem unsolvable unless someone has a change of heart, there are workarounds for those who understand the rules. One of these workarounds is the Partnership Installment Note (PIN) method. Not everyone can use this procedure, but for some, it can be a way to complete a 1031 exchange while altering the ownership of a multi-member LLC.

The Same Taxpayer Rule and Special Allocation of Gain: The Core Challenge in Multi-Member LLC 1031 Exchanges

The same taxpayer rule dictates that the taxpayer who sells the relinquished property in a 1031 exchange must be the same taxpayer to acquire the replacement property. It is not possible to use a 1031 exchange to swap an individually-held property for one held through a partnership, nor is it possible to sell a jointly-held property and acquire another as an individual without paying capital gains taxes on the sale.

For example, if you own a single-family rental property and want to sell it in order to go into business with some partners to purchase a retail storefront, you must first pay capital gains taxes on the sale of your rental property, because the taxpayer purchasing the second property will be the partnership, not you as an individual.

A common scenario is when a property is owned by a partnership or multi-member LLC (treated the same for 1031 purposes). Let’s imagine there are three members to your LLC. If the LLC sells the relinquished property, it must also purchase the replacement property. You can’t dissolve the LLC upon sale and complete a like-kind exchange using just your portion.

If two members wish to continue the partnership but one wants to exit, it is not possible to allocate the 1031 exchange boot to just one partner and allow them to leave. The boot must be distributed according to the members’ ownership stakes. If one member is going to exit this three-member LLC, they must do so before or after the exchange in a way that leaves the property-owning entity intact.

Drop & Swap, Swap & Drop, and PIN: 1031 Exchange Solutions for Exiting LLC Partners

One way to allow one member (or more, depending on the situation) to exit an LLC while leaving the entity intact is known as the drop and swap method. In our scenario with three members in an LLC, this would involve converting one member’s share to a tenancy-in-common (TIC), allowing them to sell or independently exchange their portion under Section 1031 without affecting the other owners’ shares.

Another method is the swap and drop, where the LLC completes a like-kind exchange into a series of properties that are eventually distributed to the members upon dissolution of the LLC. Both of these methods require careful planning and an understanding of state-level rules. Certain states place particular scrutiny on both TIC relationships and drop and swap transactions, so this type of 1031 exchange can be risky depending on where you live and the specifics of your situation. For some property owners, the PIN method might be a better choice.

How the Partnership Installment Note (PIN) Method Eliminates Boot and Preserves Section 1031 Tax Deferral

Let’s return to our example of an LLC with three members, and suppose the LLC owns a property valued at $3,000,000 that the members plan to sell. To fully defer taxes through a 1031 like-kind exchange, the replacement property would also have to be valued at $3,000,000. If the replacement property is worth less – say, $2,000,000 – then the exchange would involve a taxable boot of $1,000,000 (conveniently worth the same amount as one member’s share), which would be subject to capital gains taxation.

Because special allocation of gain is prohibited, if the LLC receives this cash boot, then all members would receive a portion of it consistent with their ownership percentages. They would not be able to simply give the departing partner the entire boot and let that person pay the taxes on it. The PIN method provides a way for the departing member to receive the cash boot outside the exchange, allowing the LLC to carry on in its ownership of the replacement property and continue tax deferral through Section 1031.

Under the PIN method, the LLC would sell the relinquished property (in this scenario valued at $3,000,000) to a buyer. The Qualified Intermediary (QI) would take receipt of $2,000,000 in cash and a $1,000,000 promissory note for the remaining amount (what would otherwise have become the boot). The departing partner trades their LLC ownership stake for this note. The QI then transfers the remaining cash to the owner of the replacement property. The still-intact LLC takes ownership of the replacement property, satisfying the same property rule, but with only two remaining members.

After the exchange has been completed, the buyer of the relinquished property can then make payments directly to the holder of the promissory note: the departing member of the LLC. Because the QI did not take receipt of any additional cash, the like-kind exchange has no boot, meaning the LLC has successfully deferred capital gains taxes through IRC Section 1031.

One advantage of the PIN method is that it avoids the scrutiny given to drop & swap/swap & drop transactions: when performing a drop and swap, the issue is whether the TIC relationship was carried out in a valid manner prior to the 1031 exchange; in a swap and drop, it’s whether the LLC held the replacement properties long enough before dissolving.

With the PIN 1031 exchange, because the LLC stays intact, these issues that are particular points of emphasis for some state tax boards are no longer a problem. However, there are other issues that can arise when executing a PIN exchange.

Potential Pitfalls of the PIN 1031 Exchange Method

The first major caveat for the PIN method is that it is only possible with an entity that has three or more members. With only two partners, if one departs, what’s left would be a single-member LLC, which would be taxed differently and would lose its 1031 exchange eligibility as a pass-through entity.

The second is that this method hinges on finding a buyer for the relinquished property who is amenable to this type of deal. The buyer has to be willing to pay part of the sale price on closing (the cash used during the like-kind exchange) and part later in a Section 453 installment sale – an arrangement not all buyers will accept.

For the departing partner, receiving the payment in installments can have added tax benefits if the payments are spread out over time (potentially across tax years). For the buyer, however, this could create unnecessary uncertainty and an obligation they don’t wish to carry forward. Finding a cooperative buyer is a crucial element of the PIN 1031 exchange method. Some buyers may be fine with paying part of the sale price now and part later, while some may not. Similarly, the departing partner must be willing to wait to receive their share of the business; for tax reasons, this may be advantageous, but they may have their own reasons for wanting the money now.

Another element to think about is which partners are departing and what their ownership percentages are. If, in our three-member LLC scenario, the departing partner is the one with the smallest stake, they can take their share of the sales proceeds out while still leaving the LLC with a lot of capital to acquire a valuable replacement property. But if this partner owns a majority stake, what’s left may be so small that the like-kind exchange is no longer financially viable. The remaining partners also have to think about the debt ratio of the relinquished property, as they have to match this level of debt for the replacement property.

Finally, there is the issue of what happens when this strategy fails. If the PIN 1031 exchange is deemed invalid upon audit, the LLC would be on the hook for a significant tax liability, along with associated penalties (including a potential 20% negligence penalty). With so much at stake, it’s prudent to do everything possible to ensure success, which includes working with top service providers.

Choosing the Right Qualified Intermediary for a Complex PIN 1031 Exchange

In addition to tax and legal advisors, every 1031 like-kind exchange requires a Qualified Intermediary to hold funds during the exchange so the taxpayer doesn’t take active or constructive receipt. The rules regarding who can act as your QI are rather loose, but this is not a time to cut corners. When dealing with a complex scenario like a PIN 1031 exchange, you’ll want to work with a QI that has dealt with this type of transaction before.

JTC has acted as QI for everyone from first-time property owners to major corporations, and brings decades of experience in all manner of Section 1031 exchanges. All of our clients get access to our institutional-grade security measures and our 24/7 online portal that provides full transparency during the exchange. When you’re ready to defer capital gains taxes through IRC Section 1031, get in touch with JTC to learn what our experts can bring to your exchange experience.

Learn more about JTC’s 1031 exchange services