1031 Exchanges & Partnerships: How the Drop and Swap Strategy Works
As we often discuss at Advise RE, 1031 exchanges are powerful tax-deferral tools — but they become significantly more complicated when you own property with partners.
One of the most common challenges we see:
You and your partners are selling a property with a $1 million gain.
You want to complete a 1031 exchange and defer taxes.
Your partners want to cash out.
So what happens?
The Core Problem: You Cannot 1031 Exchange a Partnership Interest
Under IRS rules, you cannot complete a 1031 exchange on a partnership interest.
If your property is owned in an LLC or partnership:
The entity must sell
The entity must reinvest
All partners must move together
That means if one partner wants to exchange and another wants cash, you’re stuck — unless you restructure before the sale.
This is where the strategy known as the Drop and Swap comes into play.
What Is a Drop and Swap?
The Drop and Swap is a pre-sale restructuring strategy designed to give partners flexibility.
Step 1: The “Drop”
Before listing or closing on the property, the partnership dissolves and distributes the real estate directly to the partners.
Ownership converts from:
LLC / Partnership → Tenants in Common (TIC)
Each partner now owns a direct percentage of the property individually.
Step 2: The “Swap”
Once the property is sold:
Partners who want cash can simply cash out
Partners who want tax deferral can complete their own 1031 exchange
Each owner controls their own tax outcome
This creates flexibility that doesn’t exist inside a partnership structure.
Why Timing Is Critical
The Drop and Swap is not something you do the week before closing.
The IRS expects that:
Each TIC owner holds their interest as an investment property
The restructuring is not merely a last-minute tax maneuver
While there is no official statutory “1-year rule,” tax professionals often reference a one-year holding period expectation to reduce audit risk.
If the drop occurs too close to the sale, the IRS may argue the exchange is invalid.
Key Risks to Understand
Before implementing this strategy, consider the following:
1️⃣ IRS Scrutiny
If the restructuring appears transactional rather than investment-driven, the exchange may be disqualified.
2️⃣ Due-on-Sale Clauses
Many loans contain provisions that may be triggered when ownership changes.
3️⃣ Insurance Adjustments
Insurance policies must reflect new ownership structure.
4️⃣ Lender Approval
Some lenders require written consent before transferring interests.
Done incorrectly, the result could be full capital gains recognition — exactly what you were trying to avoid.
When Does a Drop and Swap Make Sense?
This strategy is most appropriate when:
Partners have different investment horizons
Some want liquidity while others want long-term growth
There is sufficient time before the planned sale
Professional advisors are involved early
Proper documentation and coordination between legal counsel, CPA, lender, and qualified intermediary are essential.
Final Thoughts
The Drop and Swap can be a highly effective solution for partnerships facing conflicting tax goals — but only with advanced planning and proper execution.
If you’re considering selling a property held in an LLC or partnership, do not wait until escrow to explore your options.
Proactive planning can preserve flexibility and potentially save hundreds of thousands in taxes.
🎥 Watch Stephen Morris break down the Drop and Swap strategy in detail:
https://youtu.be/T_hjLfsdeNI?si=XEboT0G6GmvD4XP5
👉 Learn more about 1031 exchange strategies at:
https://www.adviseretax.com
