An Overview
When a partnership sells investment real estate, its partners may have different objectives. Some might want to reinvest through a Section 1031 exchange, while others may want to receive cash and leave the investment. A partnership installment note, commonly called a PIN, can help accommodate both.
The principal benefit is that a properly structured PIN can move recognition of the gain associated with the cash-out proceeds from the partnership level to the departing investor through the note. The departing investor ultimately receives the note and reports the taxable portion of its payments. The partnership uses the remaining proceeds to acquire replacement real estate for the continuing partners.
This distinction matters because simply distributing sale proceeds to the cash-out partner will generate taxable gain at the partnership level that must also be allocated in some manner to the partners, at least some of which may be allocated to the continuing partners. A PIN is designed to allow the departing partner(s) to receive proceeds and recognize the associated income individually, while preserving exchange treatment for the continuing partners.
How it Works
The transaction is arranged before the relinquished property sale closes. Ideally, the buyer of the relinquished property issues a promissory note payable to the partnership (as part of the purchase price) for the amount intended for the departing partner. However, for a variety of reasons, in most cases that is not possible or practical, in which case the qualified intermediary (“QI”) issues the note.
At closing, the sale proceeds are delivered to the QI in two separately designated tranches:
- Exchange funds, which the partnership will use to acquire replacement real estate.
- Installment note funds, which will be used to satisfy the QI’s payment obligation under the note.
The installment note funds are held in the QI’s general account. The partnership cannot have a security interest in those proceeds but may obtain a standby letter of credit.
After closing, the partnership distributes the note to the cash-out partner in complete redemption of that partner’s ownership interest. The partnership does this by executing an allonge, an endorsement to be attached to the note, assigning it to the departing investor and directing the QI to make payments to that investor. The departing investor then owns the note, and the QI pays that investor according to its terms.
A common payment schedule uses two installments: the majority shortly after the sale closes, and the balance during the first week of the following tax year. For a sale closing in 2026, the investor might receive most of the principal in 2026 and the remaining principal in January 2027.
Meanwhile, the exchange tranche remains available for the partnership’s acquisition of replacement property. The partnership must identify replacement property within 45 days and complete the acquisition within the applicable 180-day exchange period.
The tax explanation rests on two principal rules. IRC §453 generally permits installment reporting when at least one payment is to be received after the year of disposition; §453(f)(6) and Treas. Reg. §1.1031(k)-1(j)(2)(ii) coordinate that treatment with a partially taxable 1031 exchange. Treas. Reg. §1.453-9(c)(2) recognizes an exception to gain acceleration for qualifying partnership distributions of installment obligations under §731, subject to specified exceptions. Together, these rules support installment sale treatment as part of the 1031 exchange and the distribution of a qualifying installment note before payment so that the departing partner reports the taxable gain from subsequent payments.
A $10 Million Example
Assume ABC, LLC is taxed as a partnership and owns investment real estate worth $10 million, with no mortgage. Partners A and B each own 35%, and Partner C owns 30%.
A and B want ABC to complete a 1031 exchange. C wants to cash out for $3 million. Assume no selling expenses and calendar tax years.
Immediately before the sale of the relinquished property to the third-party buyer closes, the QI issues a $3 million note payable to ABC. When the relinquished property sale closes in November 2026, the proceeds are delivered from the closing escrow to the QI in two tranches:
Tranche
Amount
Purpose
Exchange Funds
$7,000,000
Acquire replacement property for ABC
Installment Note Funds
$3,000,000
Satisfy the note transferred to C
After the closing of the relinquished property sale, ABC distributes the note to C in complete redemption of C’s partnership interest and delivers a copy of the allonge to the QI. Before any payment is made on the note, C becomes the note holder.
The QI then makes the following payments:
Installment
Timing
Principal
First (90% in this case)
Shortly after the November 2026 closing
$2,700,000
Second (10%)
First week of January 2027
$300,000
ABC uses the $7 million exchange tranche to acquire replacement property within its exchange period. The acquisition follows its own schedule, subject to the exchange requirements and proper treatment of the separate installment note funds.
Assuming the structure qualifies, C reports the taxable portion of the first installment in 2026 and the taxable portion of the second installment in 2027. A and B remain invested through ABC, which owns the replacement property.
The $3 million of principal is not necessarily $3 million of taxable gain. If the note is distributed to C in complete redemption of C’s partnership interest, C takes a basis in the note equal to C’s outside basis in the partnership interest. Otherwise, C generally takes the partnership’s basis in the note, which may be zero. It is therefore very important that the distribution of the note completely redeem C’s partnership interest. C’s basis affects the taxable portion of each payment.
Comparing a PIN with a Drop and Swap
A drop and swap generally involves distributing direct, undivided ownership interests in the relinquished real estate before its sale. The owners can then pursue separate objectives: some sell for cash, while others conduct their own 1031 exchanges.
That distribution can complicate title, existing financing, and a purchase contract already negotiated by the partnership. It can also introduce seasoning issues (questions about whether the newly created ownership interests were genuinely held for investment before being sold or exchanged). Although Section 1031 establishes no fixed minimum seasoning period, a distribution immediately before a prearranged sale can be harder to support.
A PIN avoids distributing ownership interests in the real estate. The partnership remains the seller and acquires replacement property, while the departing investor ultimately receives the note.
A PIN addresses investors who want to cash out; by itself, it does not allow partners to conduct their own separate 1031 exchanges. The continuing investors remain together in the partnership and participate in its exchange. When investors want separate replacement properties through individual exchanges, a drop and swap or another partnership restructuring approach (such as the creation of multiple classes of partnership interests) must be evaluated.
A PIN structure can also be combined with a drop and swap or a partnership division when some partners want to cash out while others want to exchange separately.
Potential Issues
PINs are structured using existing exchange, installment-sale, and partnership rules, rather than a dedicated IRS approval of the complete arrangement. Their effectiveness depends on proper documentation and implementation.
An installment sale interest charge under IRC §453A may apply when qualifying installment note balances outstanding at year-end exceed $5 million. However, this rarely comes up in PIN transactions because most of the principal is paid in the year of sale.
Depreciation recapture under IRC §1245 is not eligible for installment sale treatment, so any taxable recapture is recognized in the year of sale and allocated among the partners. The redeeming partner may also bear a larger share of unrecaptured §1250 gain, which is taxable at a maximum federal rate of 25%, because that gain is generally recognized before other capital gain under the installment sale rules.
A PIN does not reduce the partnership’s debt replacement requirement in the exchange. If the property is highly leveraged and a significant number of partners want to exit, the PIN structure may not be feasible or may require the partnership to use fresh cash (non-exchange cash) to acquire its replacement property.
The parties’ CPA and attorney should review the note transfer, payment timing, treatment of the separate funds, any basis or debt considerations, and any risks involved in the structuring. Coordination with the QI before closing helps ensure that the transaction supports the intended tax treatment.
This article provides general educational information and is not tax or legal advice. Investors should consult their own CPA and attorney regarding their particular transaction.
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