Real Estate Tax Calc
The problem with partnerships and 1031s
A partnership or LLC can do a 1031 exchange, but individual partners cannot exchange their partnership interests — partnership interests are not like-kind to real property. This creates a problem when partners disagree about the exit: one wants to exchange and defer tax, another wants cash.
The drop-and-swap solves this by converting the LLC's ownership structure before the sale. The LLC distributes an undivided fractional interest (TIC interest) directly to each member — the \"drop.\" Each member then exchanges their TIC interest in their own 1031 exchange — the \"swap.\"
How the IRS views it
The IRS looks at the step-transaction doctrine and the taxpayer's intent. If the distribution and the sale happen almost simultaneously, the IRS may treat them as a single transaction and disallow the exchange, arguing the partners never truly held TIC interests for investment.
Courts have generally required a meaningful holding period between the drop and the swap — often at least one year — to demonstrate that the TIC interests were held for investment rather than solely to manufacture an exchange. Some practitioners recommend two or more years to be conservative.
Planning considerations
Before executing a drop-and-swap: (1) Confirm the LLC can distribute property in-kind without triggering gain under partnership tax rules (usually allowed under IRC 731); (2) Have all members agree on valuation of their fractional interests; (3) Establish the TIC co-ownership agreement before marketing the property; (4) Document the investment purpose for holding TIC interests; (5) Work with a qualified intermediary who is experienced with TIC exchanges.
The reverse: swap-and-drop
The mirror-image strategy is the swap-and-drop: the partnership itself completes the 1031 exchange, acquiring the replacement property in the entity's name, and only later distributes TIC interests to the members who want to go their separate ways. The advantage is that the entity clearly held the relinquished property for investment, which is rarely questioned. The risk shifts to the back end — distributing the replacement property too soon after the exchange can suggest the entity did not intend to hold it for investment.
Whether you drop first or swap first, the same principle governs: the IRS wants to see that whoever claims the exchange actually held the property for investment, both before and after. Neither variation is bulletproof, and both benefit from time between the restructuring and the transaction that raises the question.
What the 'held for' cases actually say
The drop-and-swap lives in the tension of Section 1031's requirement that property be 'held for' investment. Several court decisions have been friendly to taxpayers: in Bolker, a shareholder who received property in a liquidation and immediately exchanged it was allowed the exchange, and in Magneson a taxpayer who exchanged and then contributed the replacement property to a partnership still qualified. These cases suggest the 'held for' requirement does not demand a long holding period on its own.
But taxpayers should not over-read them. The IRS continues to assert the step-transaction doctrine where the drop and swap are effectively one prearranged plan, and results are fact-specific. The safer a taxpayer plays it — real time between steps, genuine investment conduct, contemporaneous documentation — the less room there is for the IRS to collapse the steps.
State-level disclosure and scrutiny
Some states scrutinize drop-and-swaps more aggressively than the IRS. California is the notable example: the Franchise Tax Board requires Form 3840 to be filed annually after an exchange of California property for out-of-state replacement property, and California tax returns ask directly whether the taxpayer held the relinquished interest for investment. A drop that happens on the eve of closing is exactly what these questions are designed to surface.
If you operate in a high-tax state, factor state-level review into your timeline. A structure that might survive a federal audit can still be challenged at the state level, and state clawback provisions can pull deferred gain back into income if you later sell the replacement property in a taxable transaction.
Alternatives when the timeline is too short
When partners cannot wait a year or two, other structures can accomplish similar goals. The partnership can complete the exchange as an entity and then, over time, redeem the interest of a partner who wants out. Partners can use special allocations so that the economics of a partial cash-out are handled inside the entity. In some cases the partnership simply does the exchange and the dissenting partner accepts a taxable buyout funded from other sources.
There is also the installment approach: a partner who wants cash can sometimes be bought out over time, spreading their gain under the installment method. None of these is as clean as everyone doing an independent exchange, but each avoids the step-transaction exposure of a hastily executed drop-and-swap.
A practical worked timeline
Consider a three-member LLC that owns a $3,000,000 building. Two members want to defer via 1031; one wants cash. A conservative drop-and-swap looks like this: In Year 1, the LLC amends its operating agreement and distributes undivided one-third TIC interests to each member under IRC § 731, then the members operate the property as tenants-in-common, each reporting their share of income on their own return. Roughly 18–24 months later, the property is marketed and sold. The two investment-minded co-owners each route their $1,000,000 share through a qualified intermediary into their own replacement properties; the third takes cash and pays capital gains and recapture on their share.
The gap between the drop and the swap — and the fact that each co-owner genuinely bore the risks and rewards of ownership during it — is what makes the exchanges defensible. Rushing the same steps into a single month is the classic way a drop-and-swap gets unwound on audit.
Reporting and the partnership tax mechanics
Executing a drop-and-swap changes how the property is reported. Once the LLC distributes TIC interests, the entity typically stops reporting the property on its Form 1065, and each co-owner begins reporting their share of rental income and expenses on their own Schedule E as a direct owner. This shift is part of what evidences that the members truly hold undivided interests rather than partnership interests — the reporting should match the legal reality.
When the exchanges happen, each exchanging co-owner reports their transaction on Form 8824 (Like-Kind Exchanges), and the co-owner who cashes out reports gain on Form 4797 and Schedule D. The in-kind distribution of the TIC interest is generally non-taxable under IRC § 731, but watch for two traps: a distribution can trigger gain if liabilities relieved exceed the distributee's basis, and 'hot assets' rules under § 751 can convert some gain to ordinary income. Because the partnership, distribution, and exchange rules all interact, this is a structure to run past a CPA and a qualified intermediary together — not a do-it-yourself project.
The TIC safe harbor: Rev. Proc. 2002-22
Because the co-owners must hold genuine tenancy-in-common interests rather than disguised partnership interests, the IRS's guidance in Rev. Proc. 2002-22 is the touchstone for structuring the co-ownership. It sets out conditions the IRS looks for before it will rule that a TIC arrangement is not a partnership, including: no more than 35 co-owners; the co-owners cannot file a partnership return, hold themselves out as a partnership, or operate under a business name; major decisions (sale, lease, refinancing, hiring a manager) must require unanimous approval; each co-owner must be able to transfer, partition, and encumber their own interest; and income and expenses must be shared strictly in proportion to ownership. Any management or brokerage agreement must be renewable and at arm's-length market rates. While the revenue procedure technically governs advance ruling requests, practitioners treat its factors as the practical blueprint for a defensible drop-and-swap — the closer your TIC arrangement tracks them, the harder it is for the IRS to recast the co-owners as partners who never held exchangeable real property.
Financing, suspended losses, and basis in the drop
Two practical issues surface once the TIC interests are distributed. Financing: lenders are often wary of TIC structures because each co-owner typically must be on (or consent to) the loan, and a single co-owner's default can imperil the whole property. Expect to renegotiate or assume debt at the drop, and confirm the lender will allow the fractionalization — a due-on-sale or transfer clause can be triggered by the distribution itself. Suspended passive losses and basis: when the LLC distributes the property, each member's outside basis in their LLC interest generally becomes their basis in the TIC interest received under IRC § 732, and any suspended passive activity losses tied to the interest follow the member. Those suspended losses are not automatically freed by the drop (it is not a fully taxable disposition), but they remain available against the co-owner's share of future income or on a later taxable sale of the TIC interest. Coordinate the debt, basis, and loss carryforwards with your CPA before executing, because a botched financing or basis calculation can turn an elegant plan into an unexpected tax bill.
Frequently asked questions
How long do I need to hold TIC interests before exchanging?
The IRS has not published a bright-line rule, but many practitioners recommend at least one to two years to establish a genuine investment holding period and avoid step-transaction challenges.
What is a swap-and-drop, and is it safer?
In a swap-and-drop the partnership completes the exchange first and distributes TIC interests to members afterward. It makes the relinquished-side holding clean but shifts the risk to the replacement side, where distributing too soon can suggest the entity did not hold the new property for investment. Neither variation is risk-free.
Does California treat drop-and-swaps differently?
California scrutinizes them closely. The Franchise Tax Board requires Form 3840 for exchanges of California property into out-of-state replacements and asks on the return whether the taxpayer held the relinquished interest for investment — a question aimed squarely at last-minute drops.
What if the partners can't wait a year or two?
Consider alternatives: the partnership completes the exchange as an entity and later redeems the exiting partner, uses special allocations to handle a partial cash-out internally, or buys out the dissenting partner in a taxable (possibly installment) transaction. These avoid the step-transaction exposure of a rushed drop-and-swap.
How is a drop-and-swap reported on the tax return?
After the drop, the entity generally stops reporting the property on Form 1065 and each co-owner reports their share directly on Schedule E — the reporting should match the TIC legal structure. Each exchanging co-owner then files Form 8824 for the like-kind exchange, and a co-owner who cashes out reports gain on Form 4797 and Schedule D.
Can distributing the property from the LLC ever trigger tax?
Usually the in-kind distribution is non-taxable under IRC 731, but there are exceptions. Gain can arise if the liabilities relieved on distribution exceed the distributee's basis, and the 'hot asset' rules under Section 751 can convert part of the gain to ordinary income. Review the distribution with a CPA before executing it.
Does an LLC distribution of real property trigger gain?
Generally no — under IRC 731, distributions of property from a partnership are non-recognition events for the distributee partner, with some exceptions for hot assets and liabilities exceeding basis.
Can partners also take cash while others exchange?
Yes. Each partner who receives a TIC interest can independently choose to exchange or sell. A partner who receives cash from an in-kind distribution and immediately sells simply owes capital gains tax on their share.
What is Rev. Proc. 2002-22 and why does it matter?
It is the IRS guidance that lists the factors distinguishing a genuine tenancy-in-common from a partnership — no more than 35 co-owners, unanimous approval of major decisions, proportional sharing of income and expenses, the right to transfer or partition each interest, and arm's-length management terms. Structuring the TIC to track these factors makes it far harder for the IRS to recast the co-owners as partners who never held exchangeable real property.
What happens to my suspended passive losses in a drop-and-swap?
They follow you. When the LLC distributes the property, your outside basis becomes your basis in the TIC interest under IRC 732, and suspended passive losses tied to the interest carry over. Because the drop is not a fully taxable disposition, those losses are not freed immediately — they remain available against future income from the interest or on a later taxable sale.
Will my lender allow the property to be split into TIC interests?
Not always. Many lenders are cautious about TIC structures because each co-owner usually must be on or consent to the loan, and the distribution itself can trip a due-on-sale or transfer clause. Confirm the lender's consent and any refinancing needs before executing the drop.
Sources
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.