Published 10/10/2025
What is a Drop and Swap?
What is a Drop and Swap?
When a partnership is selling real property and some of its partners want to cash out while others want to reinvest their proceeds in new property, complications arise if the reinvesting partners wish to utilize a 1031 exchange.
First, for 1031 purposes, a sale of a property interest owned through an interest in a partnership is considered a sale of the partnership interest and is not exchangeable. Second, the taxpayer that sold the relinquished property must acquire the replacement property. For example, if a partnership sells the relinquished property to a buyer, that same partnership must buy any replacement property acquired through an exchange. Individual partners may not exchange into the replacement property with proceeds from the partnership’s sale.
A common solution to the above dilemma is for the partners to dissolve their partnership prior to the sale and distribute proportionate tenant in common (“TIC”) interests in the property to each of the individual partners (this is the “drop” part of a drop and swap, since the partnership is dropped). The individual owners then deed the property to the buyer. Some of the former partners exchange their interests into replacement property (the “swap”), and the others take their cash proceeds and pay tax on their gain.
Risks of a Drop and Swap
While a drop and swap is a common structure, it is not without tax risk. In order to qualify for 1031 treatment, the property sold and the property purchased must be “held for investment” to meet the “qualified use” test that determines 1031 eligibility. Although the code does not include a specific minimum timeframe for which property must be held, if the relinquished property is transferred to the individual partners from the partnership immediately prior to its sale, the IRS may take the position that the individual partners acquired the property not for investment purposes, but for the sole purpose of selling it. Even if the original owner, the partnership, had owned the property for many years prior to the drop and swap, the individual partners may not be able to benefit from the partnership’s prior holding period. The IRS or applicable taxing authority may also take the position, using the “substance over form” doctrine, that the property interests distributed to each partner and then exchanged were in essence partnership interests, which are excluded from 031 exchange eligibility.
It is important to note that federal income tax returns for a partnership include two questions in the Schedule B portion of form 1065 that draw attention to any drop and swap transactions and heighten a taxpayer’s risk of audit. Therefore, a taxpayer should be fully prepared to defend the transaction should they decide to move forward with a drop and swap exchange.
IRS Precedent For and Against the Drop and Swap
There have been several IRS rulings, including Revenue Ruling 77-337 and Revenue Ruling 75-292, that have disqualified exchanges, reasoning that there was a qualified use issue (as referenced above), because the taxpayers dropped out of a partnership immediately before or immediately after an exchange. Courts, however, have often interpreted the holding period requirement more liberally and have permitted non-recognition of gain in 1031 transactions, even when there was a transfer immediately before or after the exchange from or to an entity controlled by the taxpayer, as seen in Magneson v. Commissioner of Internal Revenue, Bolker v. Commissioner of Internal Revenue, and Maloney v. C.I.R.
In addition to some favorable case law, the IRS decided in favor of the taxpayer in Private Letter Rulings 200521002 and 200651030. Both Private Letter Rulings addressed a testamentary trust that owned real estate and regularly did 1031 exchanges. The trust was due to terminate at a certain time and, per the trust’s termination plan, the assets of the trust would eventually be held in an LLC. The trust was expected to terminate during the exchange period in two of its transactions and immediately after the completion of a 1031 exchange in a third transaction. In each ruling, the IRS held that the termination of the trust and subsequent transfer of the properties to the LLC would not ruin the 1031 exchange transactions.
Despite these positive decisions, the IRS has not published any rulings that give investors certainty regarding the ability to defer tax in an exchange if the taxpayer uses a drop and swap structure.
Moreover, there are other methods by which the IRS may challenge a drop and swap transaction. For example, partners who drop down to tenancy in common ownership but continue to operate as a partnership for their profit and loss allocations or for their sale agreement negotiations may have a hard time arguing that they are not still operating as a partnership. In this situation, the IRS would likely find that the substance of the transaction occurred at the partnership level, rather than the individual level.
Drop and Swap 1031 Example
Imagine a partnership, such as an LLC, owns an apartment building. One partner wants to cash out after the sale, while the others want to reinvest through a 1031 exchange. To make this work, the partnership can “drop” or dissolve the partnership by distributing proportionate tenancy-in-common (TIC) interests in the property to each partner before the sale. Each partner then owns a fractional interest in the property directly, rather than as a partner in the entity.
Once the interests are distributed, the partners can go their separate ways. The partner wanting to cash out can sell their TIC interest and pay taxes on their capital gains. Meanwhile, the remaining partners—now direct owners—can “swap” their interests through a 1031 exchange by reinvesting their sale proceeds into like-kind properties, engaging the services of a qualified intermediary.
If all this is done incorrectly or too close to the sale date, the IRS may disallow the exchange, triggering taxes on the gain.
The Role of a Qualified Intermediary (QI)
In a drop and swap 1031 exchange, a qualified intermediary (QI) plays a crucial role by facilitating the exchange process for any exchanging former partners. The QI holds the proceeds from the sale of the relinquished property to prevent the taxpayer from receiving constructive receipt of the funds, which would disqualify the exchange. They also prepare the necessary exchange documents and coordinate with all parties involved. In a drop and swap scenario, the QI works closely with individual owners and their tax and legal advisors post-“drop” to structure each owner's exchange properly.
Special Drop and Swap Treatment in Different State
California
Within the last few years, California taxing authorities have paid increasing attention to drop and swap transactions. In late 2007, the California Franchise Tax Board (“FTB”) issued notice 2000 1107 02 with regard to its examination of like kind exchanges involving TIC interests. The notice indicated that the FTB would be examining whether TIC interests were actually disguised partnership interests. Although taxpayers have relied on Revenue Procedure 2002-22 to structure their TIC transactions, the FTB stated that the conditions set forth in the Revenue Procedure would be considered minimum requirements for determining the existence of a TIC interest in rental real estate. This notice serves to remind investors that a TIC interest may be characterized as a partnership interest if the transaction is not structured properly, potentially ruining an exchange.
Also in California, the Board of Equalization (BOE) issued a 2016 ruling In The Matter of the Appeal of Giurbino, Taxpayer, where it agreed with the FTB in challenging an exchange using the substance over form doctrine, deciding that the sale by individual members of an LLC that had dropped out its interests should actually be seen as a sale by the LLC, disallowing the exchange. There is one 2018 case from California where the Office of Tax Appeals in California (OTA, successor in interest to the BOE) reversed the FTB’s determination that a drop and swap exchange was invalid. In that case, they reasoned that because there was a valid business purpose of the redemption of two partners’ general partnership interests in a partnership that owned real property being sold, their dropping their interests out of the partnership simultaneously with the sale to a buyer was valid. However, later OTA decisions seem to contradict this reasoning, and the opinion is non-precedential – taxpayers in California should therefore be diligent when documenting any transactions surrounding their drop and swap and exchange transaction.
As recently as 2022, the OTA upheld the FTB’s decision to deny 1031 treatment to an exchange where after a partnership dropped its interests down to the individual taxpayers, the former partners failed to individually exercise incidents of ownership over the property prior to exchanging. Factors that the decision highlighted as important to consider in determining whether individual former partners can show they are the true sellers of a property after a partnership is dissolved and the interests distributed included:
Did the partnership, or the individual owners, take an active role in the sale and negotiations for sale of the property?
Did the former partners conduct negotiations on their own behalf with the buyer?
How much time elapsed between partnership negotiations and the exchange?
Was the sale conducted under substantially the same terms as negotiated by the partnership?
Did the partners receive the benefits and burdens of ownership of the property, prior to its sale?
New York
In a 2025 decision, the New York Division of Tax Appeals upheld a drop-and-swap structure where a tax partnership (an LLC) distributed its interest in a relinquished property to its individual members shortly after entering into a sale contract, but before the closing. The court found that the brief duration the members held title as tenants in common was not, by itself, determinative of their investment intent. Instead, it emphasized continuity of ownership and the taxpayers’ consistent investment purpose, despite a change in how the property was held (from LLC interest to direct TIC ownership). Testimony also supported that the sale was negotiated on behalf of the individual members, even if the contract initially named the LLC as seller. While this decision applies only to New York state tax treatment and doesn’t carry weight in stricter jurisdictions like California, it adds to a growing body of favorable authority and may signal a more pragmatic approach to evaluating intent and form in drop-and-swap transactions.
Drop and Swap 1031s at a Glance
A drop and swap is a complicated transaction with a variety of tax implications. Below are some practical tips; however, investors should work closely with their QI, CPA and attorney and analyze all of the tax issues involved with their specific transaction:
Drop out of the entity as early as possible before the closing of the relinquished property.
Hold the replacement property for a sufficient amount of time prior to transferring to any entity.
Maintain adequate records in order to establish evidence of intent to hold the relinquished or replacement property for business or investment purposes.
When dropping into TIC interests, follow as many of the criteria set forth in Rev. Proc. 2002-22 as possible, i.e., share in the profits and expenses on a pro rata basis.
Examine the relevant case law in addition to Revenue Procedure 2002-22.
When selling the relinquished property, negotiate and enter into the sale agreement as individuals.
Seek Help from a Qualified Intermediary Through First American Exchange Company
Whether you’re in a partnership and need to do a drop and swap, or need assistance with a different form of 1031 exchange, First American Exchange Company can help. By using a qualified intermediary, you can rest assured knowing you’re preserving your chances at a flawless 1031 exchange by using an approved IRS safe harbor.