In this guide
Why partnerships have a 1031 problem
Most investment real estate in America is owned inside LLCs and partnerships, and section 1031 contains a trap built just for them: §1031(a)(2)(D) excludes partnership interests from like-kind treatment. The entity can exchange the building it owns — that's routine. But an individual partner cannot exchange their interest in the entity, which means when a sale approaches and the partners disagree — and after a decade or a death or a divorce, partners disagree — there is no way, at the entity level, to give one partner deferral and another partner cash.
The drop and swap resolves the disagreement by dissolving the common ownership before the sale, converting each partner's non-exchangeable entity interest into directly held real estate, which is exchangeable. It's been standard practice for decades. It is also, done carelessly, one of the most commonly challenged moves in 1031 practice — both facts are true, and the difference is timing and documentation.
How a drop and swap works, step by step
| Step | What happens | The point |
|---|---|---|
| 1. The drop | The partnership deeds undivided tenant-in-common (TIC) percentages to the partners who want out (or to all partners) and the entity's ownership shrinks or the entity dissolves | Converts entity interests into direct real estate ownership |
| 2. The hold | The TIC owners hold, operate, and report their slices as direct co-owners — separate insurance, pro-rata expenses, Schedule E reporting, a co-tenancy agreement | Builds the record that each slice is investment property in its owner's hands |
| 3. The swap | The property sells; at closing, each TIC owner disposes of their slice independently — exchangers route proceeds through their own qualified intermediary, cash-out owners take their money | Each owner gets their own tax outcome and their own 45/180-day clocks |
After the swap, each exchanging owner is just a normal exchanger: identify within 45 days, close within 180, replace value and debt to avoid boot. Many drop-and-swap exchangers land in DST interests precisely because a fractional slice of sale proceeds fits neatly into a fractional replacement property — and because after years of co-owning with partners, owning something passive alone has its appeal.
The real risk: “held for investment”
Section 1031 requires that the property you exchange was held for investment or productive use — by you. A partner who receives a TIC deed on Tuesday and sells it on Thursday invites the argument that they never held it for investment at all; they merely received it to sell it. That's the entire dispute in every drop-and-swap challenge: not whether the technique is legitimate (it is), but whether this taxpayer's holding, on these facts, shows investment intent.
The case law cuts both ways, which is exactly why advisors argue about it. Taxpayers have won with strikingly short holds — in Bolker v. Commissioner (9th Cir. 1985) a liquidating distribution followed by an exchange was respected, and Magneson and related cases blessed transfers adjacent to exchanges. But the wins turned on facts and on courts willing to read intent generously, and the IRS has never conceded the point — state authorities even less so. Planning to litigate your way to deferral is not a strategy; planning so the facts never invite the fight is. One more overlay when the partners are family or affiliated entities: the §1031(f) related-party rules add a two-year holding handcuff on top of everything above.
Timing: how early is early enough?
There is no statutory answer — no safe-harbor number of days exists. What exists is a gradient of defensibility:
| When the drop happens | Position |
|---|---|
| A tax year or more before sale, before any listing | Strong — TIC owners have a real operating history under their own names |
| Before the listing agreement / LOI | Reasonable and common — the sale wasn't yet a concrete plan |
| After a signed contract, before closing | Weak — the property was already committed to sale when the partners took title |
| At the closing table (“drop at the table”) | Weakest — sometimes survives, pure facts-and-circumstances gamble |
The uncomfortable corollary: the moment partners start disagreeing about a future sale is the moment to call the tax attorney — not the week the buyer's letter of intent arrives. If you're reading this with a signed purchase agreement in hand, the honest advice is that your options have narrowed, and the conversation you need is with counsel about the specific facts, this week.
The return asks about it directly
Don't plan a drop and swap on the theory that nobody will notice. The partnership return (Form 1065, Schedule B) asks point-blank whether the partnership distributed property received in a like-kind exchange and whether it distributed tenant-in-common interests in partnership property. Answering honestly flags the transaction; answering dishonestly is a different and much worse problem. At the state level, California's Franchise Tax Board has for years treated drop-and-swap transactions as an active examination priority — relevant to any California property or California partner, and covered further in our California guide when it publishes. The professional conclusion: assume the transaction will be looked at, and build the file — co-tenancy agreement, separate reporting, operating history — so the look is boring.
The alternatives worth comparing
Swap and drop. The entity completes the exchange itself, holds the replacement at the entity level for a meaningful period, then distributes interests to partners who want out. Same destination, with the intent question moved to the calmer side of the transaction. Often better when most partners want to stay invested together.
Partnership installment note (PIN). The partnership sells with part of the price paid as an installment note allocated to the cash-out partners, spreading their gain under §453 while the entity exchanges the rest. Useful when the cash-out partners mainly want to defer, not to exit real estate.
Buy out the dissenters first. The partnership redeems the cash-out partners well before sale (they pay tax on the buyout), leaving a unified partnership free to exchange at the entity level with no drop at all — the cleanest structure when financing the buyout is feasible.
Elect out under §761(a). For narrow co-ownership situations that never really operated as a partnership, electing out of subchapter K entirely can put owners in TIC position from the start — a prevention strategy rather than a cure.
Which one fits is a facts question — partner count, state, debt, timing, and how much everyone still likes each other. This is the highest-stakes fork in partnership real estate, and it's cheap to get right early and expensive to improvise late.
Execution checklist
The file that makes a drop and swap boring to examine:
☐ Tax counsel engaged before any listing or LOI · ☐ Drop documents: deeds recorded, entity amendments or dissolution, lender consent if debt exists · ☐ Co-tenancy agreement among TIC owners (Rev. Proc. 2002-22's co-ownership factors are the drafting reference point) · ☐ Each TIC owner reports their share directly (Schedule E, insurance, bank accounts) for the full holding period · ☐ Separate QI engagement per exchanging owner — vetted through the QI directory's custody questions · ☐ Each exchanger's numbers run in advance: the 1031 calculator shows each partner what their slice defers — often the number that ends the partner argument · ☐ Form 1065 Schedule B answered accurately in the drop year.