What Is a Drop and Swap 1031 Exchange?

A drop and swap is a strategy used by real estate investors who own property through a partnership or limited liability company (LLC). It is designed to solve a common problem that arises when the owners of a property have different goals. Some partners may wish to sell the property and receive cash, while others may want to defer paying capital gains taxes by reinvesting their share of the proceeds into a new property through a like-kind exchange under Section 1031 of the Internal Revenue Code.

The fundamental issue is that a 1031 exchange requires the same taxpayer who sells the old property to be the one who buys the new property. If a partnership sells a property, the partnership itself must acquire the replacement property, which prevents individual partners from going their separate ways. The drop and swap provides a solution by changing the ownership structure before the sale.

This transaction involves the partnership first distributing ownership of the property to the individual partners, a move known as the “drop.” The partners then hold the property as tenants-in-common, meaning they each own an undivided fractional interest. Those who wish to perform a 1031 exchange can then proceed with their “swap,” while the other partners can sell their interests and cash out.

The Holding Intent Requirement

A central component of a successful 1031 exchange is the requirement that both the property being sold and the property being acquired must be “held for productive use in a trade or business or for investment.” This “holding intent” rule is where the drop and swap strategy faces its most significant challenge. The Internal Revenue Service (IRS) scrutinizes these transactions because the distribution is often immediately followed by the exchange.

From the IRS’s perspective, this timing could indicate that the individual partner never personally held the property with the required investment intent. The argument is that the partner’s true intention was always to dispose of the property in an exchange, not to hold it as an investment in their own right. This interpretation could lead the IRS to disallow the tax-deferred treatment of the exchange.

The taxpayer’s position is that their holding intent should be viewed as a continuation of the partnership’s original investment intent. Courts have, in some instances, sided with taxpayers, establishing a precedent that the partnership’s prior holding period and intent can be “tacked on” to the individual partner’s holding period. This legal concept gives the drop and swap strategy its viability, though a short holding period remains a risk factor.

Structuring the Property Distribution

The initial phase of a drop and swap transaction is the “drop,” which involves the legal distribution of the real estate from the partnership or LLC to its individual members. This is accomplished by executing and recording a deed of distribution. This legal document transfers the property’s title from the entity to the individual partners, who then hold the property as tenants-in-common (TIC) with fractional interests that mirror their ownership percentage in the partnership.

From a tax perspective, the distribution itself is generally a non-taxable event. A partner’s tax basis in their partnership interest is transferred and becomes their basis in the distributed property interest. This new basis will be used to determine the gain or loss when the partner eventually sells or exchanges their TIC interest.

To ensure the legitimacy of the distribution, the partnership agreement must be formally amended to reflect the decision to distribute the property. This amendment serves as evidence of the partners’ intent and the formal authorization for the property transfer.

Executing the Individual Exchange

Once the “drop” is complete and the partners hold direct title to the property as tenants-in-common, the “swap” phase can begin for those wishing to defer capital gains. An exchanging partner must engage a Qualified Intermediary (QI) before the closing of the property sale. The QI enters into a formal exchange agreement with the individual partner to facilitate the transaction.

At the closing of the sale, the proceeds attributable to the exchanging partner’s fractional interest are paid directly to the QI. This step is necessary to ensure the partner does not have actual or constructive receipt of the sale proceeds, which would invalidate the tax-deferred exchange. The partners who are not exchanging will receive their share of the sale proceeds directly from the closing, which is a taxable event for them.

With the funds held by the QI, the exchanging partner must adhere to the strict timelines established by Section 1031. The partner has 45 days from the date of the sale to formally identify potential replacement properties in writing to the QI. Following the identification period, the partner has a total of 180 days from the original sale date to acquire and close on one or more of the identified replacement properties.

Essential Tax and Legal Documentation

Successfully navigating a drop and swap exchange requires specific legal and tax documents to substantiate the transaction’s form and intent. An amendment to the partnership agreement should clearly articulate the partners’ decision to distribute the specific property. Following this, a Deed of Distribution must be executed and recorded to legally transfer the title from the entity to the individual partners.

For the exchanging partner, the Exchange Agreement with the Qualified Intermediary is a foundational contract that formally initiates the 1031 exchange process. To report the transaction, the exchanging partner must file Form 8824, Like-Kind Exchanges, with their personal income tax return for the year of the sale. The final partnership tax return will also report the property distribution, showing the asset leaving the partnership’s books.