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.
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.
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.