Partnership 1031 Exchange: Drop-and-Swap, Swap-and-Drop, and TIC Rules (2026)

You and a partner co-own a rental property in an LLC. You want to do a 1031 exchange into a replacement property. Your partner wants to cash out and pay the tax. This is one of the most common — and most misunderstood — situations in real estate tax planning. The problem is structural: a partnership or LLC interest is not like-kind property to real estate, so the entity itself generally can't do a 1031 exchange that benefits different partners differently. The solution requires restructuring ownership before the sale — and the IRS watches these transactions carefully.

The core problem: partnership interests are excluded from §1031

IRC §1031 provides nonrecognition treatment for exchanges of real property held for investment or productive use. But the statute explicitly lists what doesn't qualify, and partnership interests are on that list: §1031(a)(2)(D) excludes "interests in a partnership" from like-kind exchange treatment.¹

This creates a problem for any real estate held in a multi-member LLC taxed as a partnership (Form 1065). The LLC owns real estate — which qualifies for 1031. But the partners don't own the real estate directly. They own LLC membership interests — which don't qualify for 1031 treatment.

If the LLC simply sells the property and the members want to exchange, they've hit a wall: each partner's share of sale proceeds flows back to them as a capital gain on the K-1, not as exchange proceeds they can directly reinvest tax-free.

The drop-and-swap: the standard solution

The most widely used solution is the drop-and-swap: the partnership distributes the real estate to the individual partners as tenants in common (TIC), dissolving or winding down the partnership entity. Each partner now holds a direct undivided interest in the real estate — not an LLC membership interest. Each TIC owner can then sell their interest (as their "relinquished property") and do their own independent 1031 exchange into a replacement property of their choosing.

The partner who wants to cash out simply doesn't exchange — they pay their capital gains tax. The partner who wants to exchange follows the standard 45/180-day §1031 process. Each person's outcome is independent.

Step-by-step sequence:

1. Distribute the property from the LLC to the members. Under IRC §731, partners generally don't recognize gain on a property distribution from a partnership if the property's fair market value equals or exceeds the partner's adjusted basis in the partnership. Each partner receives a TIC deed reflecting their proportional ownership (e.g., 50/50 or 60/40, matching their capital account percentages).
2. File a final Form 1065 (or mark it as the final return) and issue final K-1s to each partner. The partnership ceases to be a tax reporting entity.
3. List the property for sale as a TIC. Each co-owner holds their interest as a tenant in common, which is a recognized form of real property ownership under state law and qualifies as like-kind property under Rev. Rul. 2002-22.²
4. At sale closing, each TIC interest is sold to the buyer. The QI takes custody of each exchanging partner's proceeds separately; the cashing-out partner receives their share directly and pays tax.
5. Each exchanging partner completes their own 1031 under the standard 45/180-day timeline, selecting their own replacement property independently.

The IRS risk in drop-and-swap: timing and intent

The drop-and-swap is legitimate — but the IRS scrutinizes it carefully, and there is no regulatory safe harbor that guarantees approval. The primary risk is the step transaction doctrine: if the distribution and sale are so closely coordinated that the IRS can characterize them as a single transaction, the "drop" is treated as a sham, and the original partnership (not the individual partners) is treated as the true seller. That means the exchange fails and each partner owes full capital gains tax.

A related risk is the disguised sale rules under IRC §707(a)(2)(B): if a partner receives a distribution from the partnership, and the partnership sells property within two years, the IRS presumes the distribution is part of a disguised sale of property by the partner to the partnership — which can trigger gain recognition.³

The IRS also checks Form 1065, Schedule B, Question 10: partnerships must disclose whether any member dropped out during the tax year and whether the property was subsequently sold. This disclosure signals the IRS to evaluate whether the exchange was legitimate.

What the IRS looks for in evaluating intent:

• Timing: Was the distribution recorded before a buyer was identified, before a letter of intent was signed, before the property was listed? Or was it the day before closing?
• Active ownership after the drop: Did the TIC owners collect rent, pay expenses, or make property management decisions during the holding period? Or did the property immediately go under contract?
• Documentation: Was a TIC agreement executed? Were separate tax records maintained? Did partners document their intent to hold for investment?
• Court Holding doctrine: If the partnership signed a binding contract of sale and then dropped the property to partners who ostensibly "completed" the exchange, the IRS applies the principle that the partnership (not the partners) was the true seller — voiding the exchange.

Notable case law: Bolker v. Commissioner and a line of Tax Court decisions have addressed drop-and-swap timing, generally requiring that the drop precede any binding commitment to sell. A 2010 New York Tax Court case approved a drop-and-swap that was planned and executed well in advance of the sale, with documentation of active ownership during the interim period.

The swap-and-drop: the reverse approach

The swap-and-drop is the mirror image: the partnership completes the 1031 exchange first — acquiring replacement property as the same LLC entity — and then distributes proportional TIC interests in the new replacement property to the individual partners after the exchange closes.

This structure lets the partnership use its full sale proceeds in a single exchange (simpler logistically) and then dissolve post-exchange, with each partner holding a TIC interest in the replacement property.

But swap-and-drop carries a significant additional risk: the IRS may apply the same taxpayer rule and the Court Holding doctrine in the opposite direction. If the partnership intended all along to distribute the replacement property to partners shortly after acquiring it, the IRS can argue the exchange was not made by the taxpayer who ultimately held the property — the individual partners received property they never genuinely exchanged for.

In practice, most practitioners prefer the drop-and-swap over the swap-and-drop because the individual partners are the ones completing the exchange — which is more clearly aligned with the "same taxpayer" requirement of §1031. The swap-and-drop requires keeping the LLC intact as the exchanger while simultaneously planning to dissolve it post-exchange, which is inherently more difficult to defend as non-prearranged.

TIC ownership requirements under Rev. Proc. 2002-22

For TIC interests to qualify as like-kind property in a 1031 exchange, the ownership arrangement must not be treated as a partnership for tax purposes. Revenue Procedure 2002-22 sets out 15 conditions the IRS considers when evaluating whether a TIC arrangement is a genuine co-ownership vs. a de facto partnership.² Key requirements:

• No more than 35 co-owners. This is a hard cap — husband and wife count as one person.
• No Form 1065 filing. The TIC arrangement cannot file a partnership tax return or issue K-1s. If the co-owners are operating as a partnership in substance, they don't qualify.
• TIC interests only. Title must be held as tenants in common under applicable state law, not through an LLC or partnership entity. Each co-owner holds an undivided fractional interest in the whole property.
• Unanimous consent for major decisions. All co-owners must agree unanimously on decisions like leasing to a new tenant, selling the property, borrowing money against it, or making capital improvements. No single co-owner (or supermajority) can bind the others.
• Right to partition. Each co-owner retains the right to force a partition of the property (even if they agree not to exercise it). This distinguishes TIC co-ownership from a partnership where members can't unilaterally exit with their share of assets.
• No separate business activity. The co-owners cannot conduct a separate trade or business through the property other than rental — no operations that would transform the arrangement into a joint venture.

When a co-owner wants cash: the partial cash-out problem

The most common partnership 1031 scenario: you and a partner co-own a property. You want to exchange into a larger rental. Your partner wants out — they'll pay the tax and take cash. In a drop-and-swap, this is structurally clean:

1. LLC distributes property to partners as 50/50 TIC (or whatever the actual split is).
2. Property sells. Buyer pays the full purchase price at closing.
3. At closing, your proceeds go to the QI (you're exchanging); your partner's proceeds go directly to them (they're cashing out).
4. Your partner pays capital gains tax on their share. You proceed with your 45/180-day exchange timeline.

There is no requirement that all co-owners exchange — only the ones who want to defer. Each partner's tax outcome is independent.

Worked example: $2.1M four-plex held in an LLC

Three partners co-own a 12-unit apartment building in a multi-member LLC. The property was purchased 9 years ago for $1.2M and is now worth $2.1M. They have $900K of accumulated gain ($300K each) plus straight-line depreciation of $480K ($160K each). The four-layer federal tax stack on each partner's share, if they simply sell:

If one partner wants cash and two want to exchange:

• Partner C (cash out): Receives $700,000 (their 33.3% of $2.1M), pays ~$72,000–$79,000 in federal tax, keeps ~$621,000–$628,000 after federal tax.
• Partners A and B (exchange): Each defers ~$72,000–$79,000 in federal tax. Each rolls $700,000 into a replacement property of their choosing, compounding the full pre-tax amount.

At 6% annual appreciation over 10 years, each exchanging partner defers tax on $700,000 compounding to approximately $1,253,000. Had they paid the tax upfront, only ~$625,000 compounds to ~$1,119,000. The 10-year value of the exchange vs. selling: approximately $134,000 per partner, purely from the time-value of the deferred tax — before any estate planning benefit (§1014 step-up at death).

State-level transfer tax complications

Distributing property from an LLC to individual members typically requires recording a new deed — and in states with real estate transfer taxes (New York, Maryland, Pennsylvania, and others), that deed can trigger a taxable transfer event. A $2M property in a high-transfer-tax state may incur $20,000–$60,000 in state transfer taxes on the distribution alone, even before the subsequent sale.

Some states have enacted transfer tax exemptions for distributions to partners/members — others haven't. Before executing a drop-and-swap, confirm the state-level transfer tax treatment with a local attorney. In high-transfer-tax jurisdictions, the transfer tax cost may partially offset the federal tax savings, or may require structuring the transaction differently (for example, keeping the LLC intact and having it exchange, if the partners are willing to remain in an entity together).

When the LLC exchanges directly (keeping the entity intact)

If all partners agree to continue owning the replacement property together in the same LLC — nobody wants to cash out — the LLC can simply do a forward 1031 exchange directly. The LLC is the exchanger, the LLC acquires the replacement property, and all partners' gains remain deferred inside the entity. This is straightforward and avoids the drop-and-swap complexity entirely.

The complication arises when partners disagree: some want to continue; others want to exit. In those cases, either the drop-and-swap is the mechanism (distributing before sale), or the exiting partner buys out the remaining partners' interests before the sale — which triggers gain recognition for the buying-out partners on their increased ownership share, not a 1031 issue per se but a separate tax event.

Decision framework: which structure fits your situation

Documentation checklist before executing a drop-and-swap

1. TIC agreement drafted by a real estate attorney — clearly evidencing each owner's undivided interest, management rights, and investment intent
2. Deed recording from LLC to individual TIC owners — public record of the distribution; check state transfer tax exposure
3. Final or amended Form 1065 — confirms the partnership is dissolving and each partner's final capital account
4. Rental income documentation during TIC holding period — rent checks, property management correspondence, Schedule E filings showing the property as individually owned
5. No binding listing agreement or LOI in place at time of distribution — the distribution must precede any commitment to sell
6. QI engaged before listing — exchanging partners need a Qualified Intermediary designated before the sale closes
7. Separate exchange accounts per partner — each exchanging partner's proceeds are held by the QI in their own exchange account, not commingled