Real Estate Tax Calc
The problem: conflicting partner goals
Imagine three partners who jointly own a rental. Partner A wants to cash out and retire. Partners B and C want to roll their proceeds into a bigger building. A standard partnership-level 1031 exchange requires the same entity (the LLC) to buy the replacement — which means Partner A must either agree to the exchange or accept their share of deferred gain. No partner can force the others.
The IRS also prohibits exchanging a partnership interest for real property — only real property for real property qualifies under Section 1031. This means a partner cannot simply exchange their partnership interest; the exchange must happen at the property level.
Drop and swap
The most common solution is the drop and swap: before the sale, the partnership distributes the property out to the partners as tenants in common (TIC). Each partner then co-owns a direct interest in the real property. When the property sells, each partner can independently decide whether to exchange (sending proceeds to a QI within 45 days) or take cash. Partners B and C exchange their TIC shares; Partner A takes cash and pays tax.
The IRS scrutinizes drop-and-swaps when the distribution is timed very close to the sale. The intent must be to hold for investment, not primarily to structure an exchange. A planning horizon of several months is generally advisable; a same-week distribution and sale raises red flags.
Swap and drop
The swap and drop is the reverse: the partnership completes the 1031 exchange first, acquires the replacement property, and then distributes TIC interests to partners. This avoids the pre-sale distribution scrutiny, but the IRS may look skeptically at a prearranged plan to distribute interests shortly after the exchange — particularly if the distribution was the partners' intent all along. Courts have held that the exchange and distribution must not be pre-arranged steps in a single transaction. The approach requires genuine business reasons for the post-exchange distribution timing.
Why a partnership interest cannot be exchanged
The root of the whole problem is a single sentence in the statute. Section 1031(a)(2) expressly excludes interests in a partnership from like-kind exchange treatment. So even though the partnership owns qualifying real property, a partner who wants to exchange cannot swap their partnership interest for a new property — the interest is personal property that the Code carves out. Only the partnership itself, as the owner of the real estate, can exchange the real estate.
That creates the mismatch at the heart of partner disputes. The entity can do a clean 1031 exchange, but all partners ride along with it — the deferral or the tax is shared by the whole partnership. A single partner cannot peel off their share and go a different direction without first changing who owns the real property. The drop-and-swap and swap-and-drop are both ways of solving that ownership question.
A worked example of a drop and swap
Three equal partners own a building through an LLC. It sells for $3,000,000 with a $600,000 mortgage; each partner's third is worth $800,000 of equity. Partner A wants cash; B and C want to exchange. Several months before listing, the LLC distributes the property to A, B, and C as tenants in common, one-third each, and dissolves or becomes dormant. Each now holds a direct deeded interest in the real estate.
At closing, A takes their $800,000 (through the escrow, not a QI) and reports capital gain plus their share of depreciation recapture. B and C each route their $800,000 to a qualified intermediary and identify replacement property within 45 days, closing within 180 days. Because each TIC owner is now a separate taxpayer holding real property, B and C get valid exchanges while A cashes out — the outcome the entity structure could not deliver on its own.
Holding period and the 'held for investment' problem
The vulnerability in a drop-and-swap is the requirement that exchanged property be held for productive use in a trade or business or for investment. When the LLC distributes the property days before a sale, the IRS can argue the individual partners never truly 'held' it for investment — they held it momentarily to enable an exchange. There is no statutory holding period, but the shorter the gap between distribution and sale, the weaker the position.
Two things strengthen the case: time (a distribution completed well before the property is even listed) and substance (the TIC owners actually behaving as owners — receiving their share of rent, bearing expenses, signing as principals). Some practitioners also report the intent on the return. Courts and the IRS look at the totality; a same-week 'drop' followed by a pre-arranged 'swap' is the fact pattern most likely to be recharacterized.
Swap and drop, and the step-transaction risk
The mirror strategy, swap and drop, keeps the exchange at the entity level: the LLC completes the 1031 exchange into the replacement property, then later distributes TIC interests to the partners who want to hold and lets others be bought out. The advantage is that the exchange itself is unquestionably an entity exchange of real property for real property. The risk shifts to the back end — the step-transaction doctrine, under which the IRS collapses a pre-arranged series of steps and treats the exchange-plus-distribution as if the partners had exchanged partnership interests, which is not allowed.
As with the drop, time and independent business purpose are the defense. A distribution that happens well after the exchange, for genuine reasons (a partner's later decision to retire, a refinancing, an estate event), is far safer than one baked into the original plan. Neither the drop nor the swap has an IRS blessing as a safe harbor, which is exactly why lead time matters so much.
Special allocations, the 754 election, and partner basis
When some partners exchange and one cashes out, the tax accounting inside the partnership gets detailed. The cashing-out partner recognizes gain measured against their own outside basis, which may differ from a simple one-third of the entity's inside basis — years of depreciation, prior distributions, and debt allocations all shape it. If the partnership continues after buying out a partner, a Section 754 election can step up the inside basis of the remaining assets to match what the departing partner was taxed on, preventing a later double count.
Debt allocation is another moving part: relief from a partner's share of partnership liabilities counts as a deemed cash distribution and can create taxable boot or even gain if it exceeds basis. These are not do-it-yourself computations. Any partnership contemplating a split-direction exchange should have its CPA model each partner's outside basis, debt share, and the character of their gain before committing to a structure.
Single-member LLCs are a different, easier case
Not every 'LLC' triggers the partnership problem. A single-member LLC that has not elected corporate treatment is a disregarded entity for federal tax purposes — the IRS looks straight through it to its owner. Property held in a single-member LLC is treated as owned directly by that individual, so the owner can do a 1031 exchange in their own name (or keep the same disregarded LLC on both sides) with none of the partnership-interest restrictions. This is why solo investors routinely hold each property in its own single-member LLC for liability protection without complicating a future exchange.
The complications in this article arise specifically when two or more owners share an entity taxed as a partnership. A husband and wife in a community property state can sometimes treat their jointly owned LLC as a disregarded entity too (a 'qualified joint venture' or community-property election), preserving the same simplicity. The moment a multi-member partnership return (Form 1065) is filed, though, you are in partnership territory and must use the drop-and-swap or swap-and-drop mechanics to let partners go separate ways.
Frequently asked questions
Can a partnership do a 1031 exchange if one partner wants out?
Not at the entity level if the partners disagree. A drop-and-swap allows each partner to act independently by distributing TIC interests before the sale.
Why can't I just exchange my partnership interest?
Section 1031(a)(2) specifically excludes partnership interests from like-kind exchange treatment. Only real property qualifies, so the exchange must happen at the property level — which is why partners first convert to tenancy-in-common ownership of the real estate.
What is the step-transaction doctrine and why does it matter here?
It lets the IRS collapse a pre-arranged sequence of steps and tax the substance. In a swap-and-drop, an exchange immediately followed by a planned distribution can be recharacterized as an exchange of partnership interests. Genuine time gaps and independent business reasons are the defense.
Does one partner cashing out affect the others' taxes?
It can. The departing partner's gain is measured against their own outside basis, and shifts in debt allocation can create deemed distributions. A Section 754 election may be advisable so the continuing partnership's inside basis reflects the buyout. Have a CPA model each partner's basis first.
Does a single-member LLC face these partnership problems?
No. A single-member LLC that has not elected corporate treatment is a disregarded entity, so the owner is treated as holding the property directly and can exchange it in their own name with none of the partnership-interest restrictions. The complications only arise when two or more owners share an entity that files a partnership return.
What is a drop and swap?
A drop-and-swap distributes the property out of the LLC to the partners as tenancy-in-common interests before the sale. Each partner then controls their own share of the exchange.
How long must you hold TIC interests after a drop before selling?
No fixed safe harbor exists. The IRS looks at whether the distribution was made with investment intent, not solely to facilitate an exchange. Several months to a year of holding is generally considered safer than an immediate sale.
Sources
- IRS — Like-Kind Exchanges (Real Estate Tax Tips)
- IRS — About Form 8824
- IRS Publication 527 — Residential Rental Property
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.