Understanding the “Drop & Swap” in Real Estate 1031 Exchanges

Understanding the “Drop & Swap” in Real Estate 1031 Exchanges

When a partnership owns property and some partners wish to cash out while others want to reinvest through a 1031 exchange, the “drop and swap” structure is often considered. This approach allows partners to dissolve the partnership prior to the sale, distributing direct tenancy-in-common (TIC) interests to each partner. Those seeking tax deferral via a 1031 exchange can then reinvest their share; others can receive their proceeds and recognize the gain.

Key Tax Considerations and Risks

Despite its popularity, the drop and swap carries significant tax risk. The IRS generally prohibits exchanges of partnership interests under Section 1031—each exchanging party must sell and acquire property in their own name. Importantly, for 1031 treatment, the property must be held for investment, not just briefly owned to facilitate a sale. If interests are distributed shortly before the sale, taxing authorities may argue the exchange lacks a legitimate investment intent, or that the transaction was, in substance, a partnership sale.

The IRS and California Franchise Tax Board (FTB) increasingly scrutinize these transactions, with targeted questions on partnership tax returns and guidance focusing on whether TIC interests are genuine. Recent court cases and private rulings have provided some support for the drop and swap—especially where there’s clear evidence of investment intent and independent decision-making by former partners—but there is no absolute assurance of tax deferral.

In California, tax authorities have challenged drop and swap transactions using the “substance over form” doctrine, sometimes recharacterizing TIC transfers as partnership sales. Courts have occasionally sided with taxpayers where proper documentation and sufficient independent ownership are shown, but results are mixed and not always precedential.

Best Practices

-Complete the drop from the partnership well before the sale.

-Ensure TIC owners exercise actual incidents of ownership and independent negotiation.

-Maintain documentation to establish investment intent.

-When using a TIC structure, comply with IRS guidance (Revenue Procedure
2002-22).

-Always consult a qualified tax advisor before proceeding.

Conclusion

Drop and swap transactions can provide a solution for departing and exchanging partners, but come with audit risk and require meticulous planning. When considering this structure, careful analysis and documentation are crucial for maintaining tax-deferred treatment under Section 1031.

Understanding the “Drop & Swap” in Real Estate 1031 Exchanges

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