The 1031 Drop and Swap: Resolving the Real Estate Partnership Civil War
A standard 1031 exchange requires the exact same taxpayer who sells the old property to buy the new property. When a commercial real estate asset is owned by an LLC taxed as a partnership, the *LLC* is the taxpayer, not the individual partners. If three partners own a $30M apartment building and receive a massive buyout offer, conflicts inevitably arise. Partner A wants to execute a 1031 exchange to defer taxes. Partner B wants to cash out, pay the tax, and buy a yacht. Since the LLC must act as a single unit, it cannot simultaneously sell and "partially" exchange the property without triggering massive trapped gains (boot) for the partnership. To solve this deadlock, top-tier real estate operators execute a highly scrutinized maneuver known as the "Drop and Swap." Our Real Estate Tax Advisory Group specializes in architecting the strict timeline sequencing required to survive IRS challenges on these multi-million dollar split transactions.
The Mechanics of the Drop
The purpose of the "Drop" is to dissolve the partnership entity holding the real estate *before* the sale occurs.
The LLC effectively liquidates, transferring the physical title of the apartment building out of the LLC's name and directly into the names of the individual partners as "Tenants in Common" (TIC). Now, Partner A, Partner B, and Partner C each hold an undivided individual deed to roughly 33% of the property. Because they are now individual owners (not a partnership), they are free to act independently when the buyer closes the transaction.
The Swap: Independence at Closing
When the buyer purchases the building for $30M, they are actually buying three separate 33% TIC deeds.
Partner A takes their $10M and directs it straight to a Qualified Intermediary (QI) to execute their own independent Delaware Statutory Trust (DST) 1031 exchange, deferring all taxes. Partner B takes their $10M in cash directly, pays the long-term capital gains tax, and walks away. The civil war is resolved. However, this maneuver is surrounded by IRS legal traps.
IRS Audit Traps: The Holding Period and Step-Transaction
The IRS aggressively audits Drop and Swaps using two primary weapons: the "Holding Period" argument and the "Step-Transaction Doctrine."
Section 1031 requires the taxpayer to hold the property *for investment purposes*. If Partner A receives the TIC deed on Monday and sells the property to the buyer on Wednesday, the IRS will argue Partner A never held the exact TIC deed "for investment"—they held it purely to sell it. To defeat this, our attorneys enforce strict "Seasoning Periods." The ideal drop occurs 12 to 24 months before the sale. If the buyout offer is sudden and the timeline is compressed, we orchestrate the drop to occur prior to the signing of the formal Purchase and Sale Agreement (PSA), neutralizing the Step-Transaction attack by proving the partners assumed genuine independent economic risk while holding the TIC positions.