Partnerships and LLCs that hold investment real estate face a unique challenge when it comes time to sell: not all partners may want the same thing. One partner may want to cash out, another may want to do a 1031 exchange, and a third may want to exchange into a different type of property entirely. The "drop and swap" strategy addresses this problem by distributing property interests to individual partners before the sale, allowing each to pursue their own exchange—or choose not to exchange at all.
The Partnership Problem
Under IRS rules, a partnership or LLC taxed as a partnership is treated as the taxpayer for purposes of a 1031 exchange. This means the partnership itself must acquire the replacement property—not the individual partners. If the partnership sells a property and does a 1031 exchange, the partnership must continue to hold the replacement property. Individual partners cannot simply take their share of the proceeds and do their own separate exchanges.
This creates a practical problem when partners disagree. If Partner A wants to exchange into an apartment complex, Partner B wants to buy a warehouse, and Partner C wants to take cash and pay the taxes, the partnership structure does not easily accommodate these different goals.
Key Principle
A partnership interest is not considered "like-kind" real property. A partner cannot exchange their partnership interest for real estate under Section 1031. The code explicitly excludes "interests in a partnership" from like-kind exchange treatment under IRC §1031(a)(2)(D).
What Is a Drop and Swap?
A drop and swap is a two-step transaction designed to convert a partnership-held property into individually held interests, enabling each partner to pursue their own exchange strategy.
The Process
- 1 The "Drop":
The partnership distributes the property to the individual partners as tenants in common (TIC). Each partner receives an undivided fractional interest in the property corresponding to their partnership share.
- 2 The "Swap":
Each partner, now holding a direct TIC interest in the real property, sells their individual share. Partners who want to do a 1031 exchange can proceed with their own qualified intermediary and replacement property. Partners who want cash simply take their proceeds.
The Holding Period Question
The most significant risk in a drop and swap is the holding period between the distribution and the sale. The IRS may argue that if the distribution and sale occur too close together, the transaction is a disguised sale of a partnership interest—which does not qualify for 1031 treatment.
There is no bright-line rule in the code or regulations specifying exactly how long a partner must hold the TIC interest before selling. However, the IRS and courts have looked at several factors:
Intent at the Time of Distribution
Was the distribution part of a pre-arranged plan to sell? If the sale was already under contract at the time of the drop, the IRS is more likely to challenge the transaction.
Duration of Holding
While there is no specific statutory requirement, many practitioners recommend holding the TIC interest for a meaningful period—often discussed in terms of months, not days—before selling. A longer holding period strengthens the argument that the TIC interest was held for investment.
Substance Over Form
The IRS applies a substance-over-form analysis. If the entire transaction appears to be a single pre-planned event, the IRS may recharacterize it regardless of its formal structure.
Proceed with Caution
Drop and swap transactions exist in a gray area of the tax code. The IRS has challenged these structures in the past, and court outcomes have varied depending on the specific facts. Legal and tax counsel experienced in partnership dissolution and 1031 exchanges should be involved from the outset.
The Swap and Drop Alternative
A related but distinct strategy is the "swap and drop," which reverses the order of operations. In a swap and drop:
Swap and Drop vs. Drop and Swap
The swap and drop has its own set of risks and considerations, and the same holding period concerns apply. The choice between the two strategies often depends on the specific circumstances, the timeline, and the goals of the individual partners.
Practical Considerations
- Unanimous Agreement: All partners must agree to the dissolution and distribution strategy. A single dissenting partner can complicate the entire transaction.
- Title and Transfer Costs: Distributing property from a partnership to individual TIC holders involves title transfers, which may trigger transfer taxes or recording fees depending on the jurisdiction.
- Lender Consent: If the property has existing financing, the lender must consent to the change in ownership structure. Some loan agreements contain due-on-sale or due-on-transfer clauses.
- TIC Structuring: The IRS has guidelines (Revenue Procedure 2002-22) on how TIC interests must be structured to avoid being treated as a partnership. Exceeding 35 co-owners or having overly centralized management can cause the TIC arrangement to be reclassified.
- State Tax Implications: Some states do not conform to federal 1031 exchange rules, or they impose additional requirements. State-level analysis is important, particularly when properties are located in different states.
Professional Guidance Is Essential
Drop and swap transactions involve the intersection of partnership tax law, real estate law, and 1031 exchange requirements. The stakes are high: if the IRS successfully challenges the structure, the entire tax deferral can be lost. Working with a qualified intermediary, tax attorney, and CPA who have specific experience with partnership dissolution exchanges is not just recommended—it is a practical necessity.
Navigating a Partnership Exchange?
Fidelis 1031 Exchange has extensive experience facilitating exchanges involving partnership dissolutions and drop and swap transactions. Contact us to discuss the best strategy for your partnership's situation.
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