TIC interests: eligible for a 1031 exchange
A tenancy-in-common (TIC) interest in real property is treated as a direct ownership interest in real estate. In Revenue Ruling 2002-22, the IRS confirmed that a co-owner's undivided TIC interest can be exchanged for other real property in a qualifying like-kind exchange. Each co-owner may do their own 1031 exchange independently — one co-owner can exchange while another sells outright.
Requirements: the TIC arrangement must be a true co-ownership, not a disguised partnership. Rev. Proc. 2002-22 sets out 15 conditions for a TIC interest to receive advance ruling status, including that there be no more than 35 co-owners, that a unanimous vote is required for major decisions, and that the co-owners are not conducting a business through the arrangement.
Partnership interests: not eligible
A partnership interest is explicitly excluded from Section 1031 under Section 1031(a)(2)(D). If you hold a limited partnership (LP) or general partner interest in an entity that owns real estate, you cannot exchange your partnership interest for other real property — even though the underlying asset is real estate.
This rule catches investors off guard when a group of people own rental real estate through an LLC taxed as a partnership. The entity can do a 1031 exchange on the whole property, but an individual partner who wants to exit cannot do their own 1031.
The drop-and-swap solution
The drop-and-swap is the standard workaround: before the sale, the partnership distributes its property interest to the partners as TIC interests (the 'drop'). Each partner now holds a direct TIC interest in the real estate. Then the property is sold and each partner can exchange their TIC share independently (the 'swap').
Key risk: the IRS may challenge a drop-and-swap if the conversion to TIC happens immediately before the sale, arguing the TIC interests were not held for investment. Best practice is to hold the TIC interests for a meaningful period before the exchange and document the investment intent. Consult a qualified intermediary and tax counsel before executing this strategy.
The 15 conditions of Rev. Proc. 2002-22 in practice
Rev. Proc. 2002-22 lists the conditions the IRS uses to decide whether a co-ownership is a genuine TIC (which qualifies for Section 1031) or a disguised partnership (which does not). You do not have to request an actual private letter ruling, but the factors are the practical checklist advisors use to structure a defensible TIC:
No more than 35 co-owners. A husband and wife, or an owner and their disregarded single-member LLC, count as one.
No entity-level activity. The co-owners cannot file a partnership return, hold themselves out as a partnership, or operate under a common business name.
Unanimity for major decisions. Selling, leasing, refinancing, or hiring a manager for the whole property should require the consent of all (or in some structures a supermajority) co-owners — not a controlling manager acting alone.
Proportionate sharing. Each co-owner shares revenues and costs strictly in proportion to their undivided percentage, holds title as a tenant in common, and has the right to partition or sell their own interest.
The more the arrangement looks like an active joint business run by managers, the more likely the IRS treats it as a partnership and denies the individual co-owner's exchange.
Delaware Statutory Trusts as a replacement option
Many investors selling a TIC interest — or exiting a partnership through a drop-and-swap — want passive replacement property rather than another actively managed building. A Delaware Statutory Trust (DST) is the common answer. In Revenue Ruling 2004-86, the IRS held that a beneficial interest in a properly structured DST is treated as a direct interest in real estate, so it qualifies as like-kind replacement property in a 1031 exchange.
A DST lets a co-owner roll exchange proceeds into a fractional interest in institutional-grade real estate (apartments, industrial, medical office) without managing it. The trade-offs: DST interests are illiquid, the sponsor controls the property under the '7 deadly sins' restrictions that keep the DST from looking like a partnership, and you cannot refinance or contribute new capital. DSTs are frequently used to solve the 'I have leftover exchange value and can't find a property in 45 days' problem.
A worked drop-and-swap timeline
Assume four individuals own a $2 million apartment building through an LLC taxed as a partnership. Two partners want to cash out and pay tax; two want to defer via 1031. A typical sequence:
Step 1 — the drop. Well before listing, the LLC distributes the real estate to the four members as TIC interests (a 25% undivided interest each) and the LLC is dissolved or left dormant. This is generally tax-free under Section 731 for a distribution of property.
Step 2 — the holding period. The former partners hold their TIC interests directly, reporting rental income on their own Schedule E, ideally across a tax year boundary to show the interests were held for investment rather than for immediate resale.
Step 3 — the swap. When the building sells, the two deferring co-owners each route their 25% of the proceeds through a qualified intermediary and acquire replacement property (or a DST interest); the two cashing out simply report their gain. Each co-owner's tax outcome is independent.
The weak point is always timing. Case law (e.g., Bolker and later cases) supports drop-and-swaps done with real substance, but a same-week drop-then-sale looks like the partnership sold the property and assigned the gain.
The swap-and-drop and other variations
The mirror-image strategy is the swap-and-drop: the partnership itself completes the 1031 exchange into replacement property, then later distributes TIC interests in the new property to the partners who want out. This shifts the holding-period risk to the back end — the replacement property should be held by the partnership for a period before distribution to show investment intent. Advisors debate whether drop-and-swap or swap-and-drop is safer; both rely on the property (old or new) being held long enough that the individual, not the partnership, is seen as the true 1031 exchanger.
A cleaner but slower alternative is simply to plan ahead: if the co-owners know they will want independent exits, holding the property as a genuine TIC from the outset — with proportionate ownership, unanimous major decisions, and no partnership return — avoids the drop entirely and removes the timing risk. When a full 1031 is impractical for a departing owner, a partial exchange (deferring part and paying tax on boot) or an installment sale of that owner's share may be more workable than forcing a rushed conversion.
Common mistakes with partial-interest exchanges
Assuming an LLC interest qualifies. It does not — the exclusion in Section 1031(a)(2)(D) is explicit, and this is the single most common misunderstanding.
Doing the drop too late. Distributing property to partners days before closing invites an IRS recharacterization. Build in as much holding time as the deal allows.
Ignoring the single-member LLC option. A co-owner can take title through a wholly owned, disregarded single-member LLC and still be treated as the direct owner for 1031 purposes — useful for liability protection without creating a partnership.
Forgetting debt. Each co-owner must independently satisfy the reinvestment and debt-replacement rules on their share, or they receive taxable boot.
State conformity and reporting
Most states follow the federal 1031 rules, but a few require add-back or 'clawback' reporting. California, for example, requires Form 3840 to track deferred gain when you exchange California property for out-of-state replacement property, and will tax the deferred gain when the replacement is eventually sold in a taxable transaction. Pennsylvania historically did not conform to Section 1031 for personal income tax purposes on certain transactions, though its treatment has evolved — confirm the current rule.
Report the exchange on Form 8824 for the year the relinquished property is transferred. In a drop-and-swap, each co-owner files their own Form 8824 for their TIC share. Keep the LLC dissolution documents, the TIC agreement, and evidence of the holding period with your permanent tax records.
Frequently asked questions
Can I do a 1031 exchange on my share of a co-owned rental?
Yes, if you hold a tenancy-in-common (TIC) interest directly in the real property. Each co-owner can exchange independently.
Can I 1031 exchange my LLC membership interest?
Generally no. An LLC interest is treated as a partnership interest under Section 1031(a)(2)(D) and is not eligible for a like-kind exchange, even if the LLC holds real estate.
What is the drop-and-swap?
A strategy where a partnership distributes property to its partners as TIC interests, then each partner does their own 1031 exchange when the property is sold. It requires careful timing and documentation to withstand IRS scrutiny.
Can I use a Delaware Statutory Trust as replacement property?
Yes. Under Rev. Rul. 2004-86, a beneficial interest in a properly structured DST is treated as a direct interest in real estate and qualifies as like-kind replacement property. DSTs let a co-owner reinvest passively without managing a building.
How many co-owners can a TIC have and still qualify?
Rev. Proc. 2002-22 caps a ruling-eligible TIC at 35 co-owners, treating a married couple or an owner and their disregarded LLC as one. Beyond that, or where co-owners run a common business, the IRS is more likely to treat it as a partnership.
How do I report a drop-and-swap exchange?
Each co-owner files their own Form 8824 for the tax year the relinquished property transfers, reporting only their TIC share. Keep the LLC dissolution and TIC agreement documents to support that you held a direct property interest, not a partnership interest.
Does taking title through a single-member LLC break the exchange?
No. A wholly owned single-member LLC is a disregarded entity, so its owner is treated as the direct owner of the real estate for 1031 purposes. This lets a co-owner get liability protection without creating a partnership interest.
Sources
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.