1031 Exchanges for Partnerships and LLCs: Drop and Swap Explained

When a partnership or multi-member LLC owns investment property, the partners rarely agree on what to do after a sale. Some want to exchange into new property, some want cash, and some want to go their separate ways. A 1031 exchange can still work, but the rules about who the "taxpayer" is make partnership exchanges more complicated than individual ones. This guide explains the options, including the structure known as a "drop and swap."

The basic problem: the partnership is the taxpayer

Two rules shape every partnership exchange:

• The same taxpayer must sell and buy. If the partnership owns the property, the partnership has to be the one that acquires the replacement property. An individual partner can't take their share of the sale proceeds and buy property in their own name as part of the partnership's exchange.
• Partnership interests can't be exchanged. Partnership interests have been excluded from Section 1031 since 1984, and since 2018 the section applies only to real property. A partner can't exchange their partnership or LLC interest for real estate. (A narrow exception applies to partnerships that elect out of partnership tax treatment under Section 761(a), which are treated as owning their property directly.)

(An LLC with a single member is usually disregarded for tax purposes, so its owner is treated as owning the property directly. The issues below apply to LLCs taxed as partnerships.)

Option 1: The partnership exchanges as a whole

If all the partners want to stay invested together, this is the simplest path. The partnership sells, its qualified intermediary holds the proceeds, and the partnership buys the replacement property. Nothing changes for the partners except the property they own through the partnership.

If a few partners want out, the partnership can complete its exchange first and buy out or redeem those partners later, after the replacement property has been held for a while. The departing partners' tax consequences then depend on how the buyout is structured, so involve your CPA.

Option 2: Partners who want cash take it at closing

The partnership can exchange most of the proceeds and distribute some cash at closing. But any cash the partnership doesn't reinvest is taxable boot to the partnership, and the resulting gain flows through to the partners based on the partnership agreement. Unless the agreement and the tax allocations are handled carefully, partners who stayed in the exchange can end up sharing the tax on cash they never received.

Option 3: Drop and swap

In a drop and swap, the partnership first distributes the property to the partners as tenants in common, each owning an undivided percentage of the property directly (the "drop"). When the property sells, each co-owner sells their own interest and makes their own choice (the "swap"): one can exchange through a qualified intermediary, another can take cash and pay the tax, and another can exchange into something completely different.

A related structure, the swap and drop, reverses the order: the partnership completes the exchange, then later distributes interests in the replacement property to the partners.

The risks

Drop and swaps are common, but they are not risk-free. The main challenges a tax authority can raise are:

• The "held for investment" test. Section 1031 requires that the property be held for investment or business use. If partners receive their interests shortly before a sale, a tax authority may argue they held the property only to sell it.
• Substance over form. If the sale was negotiated by the partnership before the drop, the IRS may argue the partnership, not the individuals, was really the seller.
• A partnership in disguise. If the co-owners keep acting like a partnership (sharing profits through one account, filing a partnership return, making decisions as a group), the tenancy in common may be treated as a partnership, and the individual exchanges can fail.

Federal courts have supported taxpayers in several cases, notably Bolker (Ninth Circuit, 1985, involving a corporate distribution before an exchange), Magneson (Ninth Circuit, 1985, an exchange followed by a contribution to a partnership) and Mason (Tax Court, 1988, a partnership distribution before an exchange). But partnership tax returns include questions that flag distributions of property, and California's Franchise Tax Board has been especially aggressive in challenging drop and swaps, even though California's Office of Tax Appeals ruled for the taxpayer in a 2018 case.

How to reduce the risk

• Drop early. The more time between the distribution and the sale, the stronger the investment argument. Many advisors prefer the co-owners hold their interests through at least one tax filing period before selling.
• Make the change real. Record new deeds, sign a tenancy in common agreement, get lender consent, notify tenants and handle any transfer taxes.
• Act as separate owners. Each co-owner should sign the sale contract individually, receive their own share of income and expenses, and stop filing as a partnership for that property.
• Get advice before anything is signed. Structure the drop with your attorney and CPA, ideally before a buyer is found.

Option 4: Exchange into a DST or separate properties

Once partners hold their own interests, each can choose replacement property that fits their own goals, including fractional interests such as a Delaware Statutory Trust for owners who want a passive investment. Each co-owner then has their own 45- and 180-day deadlines and their own exchange agreement.

Which option fits?

• Everyone wants to stay together: exchange as a partnership.
• A few partners want out and timing is flexible: exchange, then buy them out later.
• Partners want different outcomes from the same sale: consider a drop and swap, planned well ahead of the sale.

Partnership exchanges are decided long before closing. If your property is held in a partnership or LLC and a sale is on the horizon, talk to us and bring your CPA and attorney into the conversation. We will coordinate each co-owner's exchange so the documents, deadlines and funds stay separate.