How a Drop & Swap 1031 Exchange Lets You Dissolve a Partnership AND Defer Taxes

Understanding how a drop and swap works, the risks involved, and setting yourself up for exchange success with careful planning.

A Section 1031 like-kind exchange can allow a property owner to defer capital gains taxes, depreciation recapture, and other taxes on the sale of property held for business or investment use when the sales proceeds are used to purchase like-kind property. A like-kind exchange can be a smart retirement or estate-planning strategy and can aid the growth of small businesses.

Many types of properties can qualify as like kind, and many ownership structures can be used to own property eligible under Section 1031. In addition to common structures like single-member LLCs, it’s also possible to own property with others through partnerships, multi-member LLCs, tenancy-in-common, and other arrangements.

While all of these structures offer different benefits depending on the situation, the choice or ownership structure has significant ramifications for the future. When you eventually sell your property, you’ll have to choose between a 1031 exchange and a taxable sale. If you own the property as part of a partnership or multi-member LLC, and you and your partners don’t all agree about whether to cash out or perform an exchange, you may run into trouble.

The same taxpayer rule and why partnerships can create problems for exchangers

One of the most common mistakes made by first-time exchangers is a failure to understand the same taxpayer rule, which states that the taxpayer that acquires the replacement property must be the same taxpayer that surrendered the relinquished property.

For those who own property as part of a partnership or LLC, this means that the entity that held and sold the relinquished property must be the same entity that purchases the replacement property. You can’t form a new entity while exchanging or dissolve the partnership during the exchange.

According to IRC Section 1031(a)(2), interests in a partnership are not eligible for non-recognition of gain under Section 1031. That means you can’t use your partnership interest as the relinquished property for an exchange. It won’t matter if you use the sales proceeds to purchase an investment property, just as it won’t matter what property is owned through the partnership. It’s the partnership that owns the underlying property; what you own is an interest in that partnership, and partnership interests are not exchangeable.

If one member wants to end the partnership while the others don’t, that individual partner can’t sell their interest and exchange into another partnership or like-kind property. If the partners agree to sell a property held by the partnership, but only one of them wants to perform a like-kind exchange, that partner can’t perform an exchange with only their portion of the proceeds because it would violate the same taxpayer rule.

When a partnership or multi-member LLC sells investment property, the members must agree on whether to perform a 1031 exchange or cash out. If they choose an exchange, the partners must stick together and continue the partnership. To avoid the kinds of conflicts that can arise when partners don’t agree, another ownership structure provides options.

The benefits of TIC structures

A tenancy in common (TIC) is a relationship where multiple tenants own fractional interests in a single property. Individual interests can be sold or bequeathed independently of the other owners, including through 1031 exchanges. This means you can perform a 1031 exchange with only your portion; the other tenants do not have to sell, or could choose to sell and pay taxes on their portions.

To learn more about tenancy-in-common relationships, read our blog on the subject.

Even if you already own property as part of a partnership or multi-member LLC, it could be possible to transition to a TIC, which would then allow you to execute a 1031 exchange with your portion of the property. For those who are currently involved in partnerships they’d prefer to dissolve, transitioning to a TIC might be better than simply selling the partnership interest.

Drop & swap: how to go from a partnership or LLC to a TIC

As mentioned, partnership interests can’t be exchanged under Section 1031. However, there are situations where a partnership might not be considered a business entity, in which case shares could be exchangeable. IRS Revenue Procedure 2002-22 outlines some of these situations, and is worth understanding if you believe your partnership shouldn’t qualify as a business entity.

For other situations, the way to exit a partnership or LLC and enter into a TIC relationship that subsequently performs a 1031 exchange is by executing something called a “drop and swap.” This method moves property from entity-level ownership (like a multi-member LLC) to individual-level ownership.

In a drop and swap, the partnership is dissolved prior to the sale of the relinquished property. When the partnership is dissolved, ownership of the property is distributed as proportional TIC interests held by the former partners (now tenants in common). This is the “drop” portion of a drop and swap.

From there, each tenant can decide what to do with their TIC interest. They can sell their interest and perform a 1031 exchange (“swap”), continue to hold, or sell and pay taxes on the gain.

For multi-member LLCs, all members can become tenants-in-common as above, or one member can transfer their interest to the LLC in exchange for a percentage ownership interest in the property equivalent to their relinquished membership interest. At this point, the exiting member becomes a tenant-in-common with the LLC. When the property is sold, the individual who exited the LLC receives a proportional interest, as does the LLC. The remaining members of the LLC can continue at the entity level, while the individual exits, each doing what they decide with their portion of the sales proceeds.

If the LLC is being dissolved and all members becoming tenants-in-common, a final tax return must be filed for the LLC. If only one member is exiting, the LLC can continue operating as before. Even if all members wish to dissolve the entity, it could be advantageous to continue the LLC for purposes of the exchange because of another method called a “swap and drop.”

The swap & drop method for LLCs

A swap and drop is for members of an LLC who all want to exchange into new properties, but don’t want to continue their partnership. Maybe they owned commercial real estate and want to exchange into three separate single-family rental homes, or own a portfolio of properties and each wants to pursue a different strategy going forward.

Dissolving an LLC and calculating the proportional interests could be complicated and time-consuming, presenting a problem if you’ve found a buyer for a relinquished property or seller of a replacement property who wants to act now. There is also the matter of the holding period: as we’ll explain in more detail later, in a drop and swap, It is not recommended to sell property immediately after converting to a TIC relationship. But if an opportunity is available now, you may not want to wait.

To avoid this trouble, the members can agree to keep the LLC intact for the time being. The LLC can perform a multi-property exchange (or series of exchanges) at the entity level and acquire the properties the members wish to retain individually once the LLC is dissolved. The LLC can then hold the replacement properties for a period of time (1031 best practices generally recommend a two-year holding period), at which point the LLC will be dissolved and the properties distributed to the individual members according to their agreement.

A swap and drop is often seen as a more conservative method than a drop and swap because it eliminates worries about the holding period. However, a swap and drop requires all members to agree on continuing the LLC relationship and tracking profit/loss on the properties to allocate accurate percentages upon dissolution after the holding period ends. Because of this, the swap and drop method is less common than a drop and swap.

The risks of a drop & swap

The biggest issue in a drop and swap is how long the TIC interest will be held between the time the drop is performed and when the swap begins. Unfortunately, the IRS has never clearly defined how long a property must be held before an exchange. Section 1031 simply requires that a property be held for investment or qualified business use, not for a certain amount of time.

The issue is intent: if the property (or TIC interest) is transferred to the individual and then immediately sold as a relinquished property, the IRS may determine that it was acquired solely for purposes of sale, even if the partnership held the property for many years prior to dissolution. Holding the property for a period of time prior to your exchange may satisfactorily prove intent, but as there is no clearly-defined period that a property must be held, you can’t necessarily be sure when you’ve held your property long enough.

For those looking to perform a drop and swap in as short of a time frame as will be allowed, there is some legal precedent. To give yourself the greatest likelihood of exchange success, it is crucial to consult with experienced tax and legal experts who understand recent interpretations and best practices.

If the parties in a partnership receive TIC interests that are then exchanged, the IRS could determine that what was distributed was essentially a partnership interest, which can’t be exchanged under Section 1031. IRS Form 1065 contains questions regarding distributions of a partnership for these situations.

To avoid IRS scrutiny, the dissolution of the partnership must be legitimate. Once the drop has occurred, the tenants-in-common should not continue to operate in the same way they did when they were partners when it comes to profit and loss allocations, payment of operating expenses, or sales negotiations.

Proper documentation at every step is crucial. The IRS heavily scrutinizes drop and swaps, so it’s important to document the transition from partnership to TIC in addition to each step of the 1031 exchange. Treatment can also vary by state, so understanding your state’s tax rules and treatment of TIC interests from dissolved partnerships will be critical.

A drop and swap is not like an average 1031 exchange, and you shouldn’t work with an average Qualified Intermediary. JTC’s team has extensive experience with drop and swap transactions all over the country, and can provide easy access to necessary documentation through our 24/7 online portal. Before you decide whether to go ahead with a drop and swap, talk to a JTC representative about how we can help.