Can an LLC Do a 1031 Exchange?

Single-member LLC: no problem

A single-member LLC (SMLLC) is a disregarded entity for federal tax purposes — the IRS treats it as indistinguishable from its sole owner. When an SMLLC sells a property and buys a replacement within the 45/180-day windows, the exchange is valid. The taxpayer is the individual (or corporation) who owns the LLC, and they are the same on both sides of the exchange. From a 1031 standpoint, the LLC wrapper is transparent.

Multi-member LLC (partnership): the same-taxpayer rule

A multi-member LLC is treated as a partnership for tax purposes. The partnership itself is the taxpayer, not the individual members. For a 1031 exchange to work at the entity level, the partnership must sell the relinquished property AND acquire the replacement property. This works fine if all partners agree — they all stay in the partnership and roll into the new property together.

The problem arises when partners disagree: one wants to cash out and another wants to continue. You cannot exchange a partnership interest for real property or vice versa — only real property for real property (or personal property for personal property of the same class). The solution most commonly used is the drop and swap: the partnership distributes undivided tenancy-in-common (TIC) interests to the partners before the sale, each partner holds as a co-owner, and each independently decides whether to exchange or cash out.

Drop and swap planning considerations

The drop-and-swap must be done carefully. The IRS requires that any property used in a 1031 exchange be held for investment or use in a trade or business — not primarily for sale. A distribution of TIC interests immediately before a prearranged sale is scrutinized. No fixed safe harbor exists, but IRS private letter rulings suggest that a holding period of several months to a year helps establish investment intent. Plan well in advance, not the week before closing.

Drop and swap vs. swap and drop

The drop and swap distributes tenancy-in-common interests to the partners before the sale, so each partner (now a direct co-owner) independently exchanges or cashes out. The mirror-image swap and drop has the partnership complete the exchange first and then distribute interests in the replacement property to the partners afterward. Both work around the rule that a partnership interest is not like-kind to real property, and both live or die on the same requirement: the property must be held for investment or productive use by the exchanging taxpayer.

The timing risk cuts in opposite directions. A drop just before closing invites the argument that the individual co-owners did not 'hold' their TIC interests long enough for investment; a drop just after invites the argument that the partnership, not the individuals, was the true exchanging party. Neither has a statutory safe harbor, so the more separation (a longer holding period, separate tax reporting, genuine co-ownership decisions) you can build in on either side, the stronger the position. Some states, notably California, actively scrutinize these transactions.

Cashing out one partner while the rest exchange

When most partners want to reinvest but one wants cash, several structures exist short of a full drop-and-swap. The partnership can complete the exchange and take a small amount of boot (cash) equal to the departing partner's share, then specially allocate the resulting recognized gain to that partner under the partnership agreement — the continuing partners keep their deferral. Alternatively, the partnership can redeem the exiting partner's interest before the exchange (sometimes funded by a pre-sale refinance, though loan proceeds taken out too close to the sale can be recharacterized). A more advanced route is a partnership installment note. Each of these has traps around disguised sales, the anti-abuse rules, and debt-financed distributions, so they belong in a tax advisor's hands, not a DIY closing.

Using a new single-member LLC to take title

The disregarded-entity rule also creates useful flexibility on the acquisition side. Because a single-member LLC is invisible for federal tax, you can sell the relinquished property in your individual name (or in an existing SMLLC) and take title to the replacement property in a newly formed SMLLC that you wholly own — the taxpayer is still you, so the same-taxpayer rule is satisfied. Investors do this constantly to isolate each property's liability in its own LLC while preserving the exchange. The key is that the new LLC must be genuinely single-member and disregarded; adding a second member (even a spouse in a non-community-property state) converts it to a partnership and can break the same-taxpayer chain.

Practical checkpoints: lenders, title, and state taxes

Before restructuring around a 1031, clear the non-tax hurdles. A distribution of TIC interests or a change of vesting can trigger a lender's due-on-sale clause or require consent, and lenders financing the replacement property often dislike fractional TIC ownership. Retitling can also trigger real estate transfer taxes in some jurisdictions and can reset property-tax assessments where reassessment is triggered by ownership changes. Finally, confirm state conformity: most states follow federal 1031 treatment, but a handful impose clawback reporting (California's FTB Form 3840, for example) to tax deferred gain if you later sell an out-of-state replacement property. Line up title company, lender, and state advice alongside your Qualified Intermediary well before the 45-day identification clock starts.

Tenancy-in-common: the form that keeps it out of partnership territory

Because a drop-and-swap depends on the distributed interests being real property and not disguised partnership interests, the co-ownership has to look like genuine tenancy-in-common (TIC) ownership. IRS Revenue Procedure 2002-22 lists the factors the Service weighs before it will rule that a TIC arrangement is co-ownership of real estate rather than a partnership: generally no more than 35 co-owners; the co-owners cannot file a partnership return, hold themselves out as a partnership, or conduct business under a common name; major decisions (sale, lease, refinancing, management hire) should require unanimous or near-unanimous consent; each owner should be able to transfer, partition, or encumber their interest; and income, expenses, and debt must be shared strictly in proportion to ownership.

This is exactly the opposite of how most operating partnerships behave, which is why the drop must be real: the former partners need to act as true co-owners, each free to exchange or cash out on their own. The more the group continues to operate like a partnership after the drop — pooling decisions, sharing disproportionately, acting under the old entity name — the more likely the IRS treats the 'TIC interests' as partnership interests that were never eligible for the exchange.

Common mistakes and a planning timeline

The recurring mistakes are timing mistakes. Partners try to drop TIC interests days before closing, which is the weakest possible fact pattern for investment intent. They add a second member to an LLC that is taking title, unintentionally converting a clean disregarded entity into a partnership and breaking the same-taxpayer chain. They sell as the partnership and try to buy as individuals (or vice versa) without a supporting structure. And they engage a Qualified Intermediary too late — you must have the QI in place before the relinquished property closes, because once you have actual or constructive receipt of the proceeds the exchange is dead.

A workable timeline: decide months ahead whether the group is exchanging together or splitting up; if splitting, complete the drop to TIC well before listing the property and give the co-owners time to hold and report separately; confirm the entity that will hold each replacement property (individual, existing SMLLC, or a new disregarded SMLLC per property); and line up the QI, lender, and title company before the sale contract is signed. Given the anti-abuse exposure, a partnership 1031 is one of the clearest cases for hiring an experienced tax advisor rather than improvising at the closing table.

Frequently asked questions

Sources

• IRS — Like-Kind Exchanges (Real Estate Tax Tips)
• IRS — About Form 8824

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

Related

• 1031 Exchange Calculator
• The Drop-and-Swap 1031 Exchange for Partnerships
• Tenancy-in-Common (TIC) for a 1031 Exchange