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.
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.
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.
Sources
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.