What Is a Drop and Swap 1031 Exchange?

A “drop and swap” is a strategy for real estate partnerships where partners have different goals for a property sale. Some partners may want to cash out and pay taxes, while others wish to defer capital gains taxes through a 1031 exchange. The primary function of the strategy is to restructure the property’s ownership before the sale. This allows partners who want to reinvest to do so on an individual basis, separating their transaction from those exiting the investment. It addresses a tax code limitation that prevents exchanging a partnership interest for real estate, effectively converting an ineligible asset into an eligible one for the willing participants.

Foundational Requirements for the Transaction

A successful drop and swap hinges on two rules. First, Section 1031 of the Internal Revenue Code prohibits exchanging partnership interests for like-kind property, as a partnership interest is considered personal property, not real estate. Second, for an exchange to be valid, the same taxpayer who sells the relinquished property must acquire the replacement property. If a partnership sells a building, the partnership must buy the new one, preventing individual partners from using their proceeds for separate exchanges.

Any 1031 exchange has a “held for investment” requirement, meaning both the sold and acquired properties must be held for business use or investment. In a drop and swap, the IRS may question whether the individual partners, after receiving their direct interest, held it for a sufficient investment purpose. An interest acquired merely as a transient step to facilitate an immediate sale may be challenged. A very short holding time between the “drop” and the “swap” increases the risk of the transaction being disallowed, though no specific holding period is defined in the tax code.

The solution is to convert ownership into a Tenancy-in-Common (TIC), which is a form of direct, fractional ownership of the real estate. Unlike a partnership interest, a TIC interest means each owner holds a direct title to a percentage of the property. This makes a TIC interest a qualifying asset for a 1031 exchange because it is considered real property.

For the IRS to recognize the TIC arrangement, certain conditions must be met. Co-owners must share revenues and costs in proportion to their ownership percentage. Each co-owner must have the right to transfer, mortgage, or partition their interest without the consent of others. The arrangement cannot file a partnership tax return or operate under a common business name.

The “Drop” Process Step-by-Step

The “drop” process begins when partners formally agree to the plan, which may require amending the partnership’s operating agreement. This involves a vote to approve either the dissolution of the partnership or the distribution of the real estate asset. This decision authorizes the transfer of the property title from the partnership to the individual partners.

Next, a Tenancy-in-Common (TIC) agreement is created to govern the relationship between the new co-owners. This legal document is separate from the partnership agreement and outlines the rights and responsibilities of each owner. It details the proportional sharing of expenses and income, management duties, and dispute procedures. The agreement helps demonstrate to the IRS that the co-owners are operating under a true TIC structure.

The next step is the legal transfer of the property’s title. An attorney prepares a new deed that conveys the property from the partnership to the individual partners as tenants-in-common. The deed specifies the fractional interest each partner owns and must be signed and recorded with the local government authority to be effective.

After the property transfer, administrative tasks finalize the ownership change. The lender on any outstanding mortgage must be notified of the title change. Property and liability insurance policies must also be updated to list the new co-owners as the insured parties to maintain compliance and proper coverage.

The “Swap” Process Step-by-Step

Once the “drop” is complete, partners intending to perform an exchange must engage a Qualified Intermediary (QI) before the property sale closes. The QI is a neutral third party that holds the sale proceeds to prevent the partner from having constructive receipt of the funds, which would invalidate the tax deferral. An exchange agreement with the QI must be executed before the property is sold.

Next is the sale of the co-owned property. At closing, proceeds are divided based on TIC ownership percentages, with funds for cashing-out partners paid directly to them. The proceeds for partners performing a “swap” are sent directly from the closing agent to the QI, and this separation of funds is documented on the settlement statement.

After the sale, the exchanging partner enters a 45-day identification period. Within this timeframe, the partner must formally identify potential replacement properties in a signed, written document delivered to the QI. IRS rules permit several identification methods, such as the three-property rule, which allows identifying up to three properties of any value. Another option is the 200% rule, which allows for identifying any number of properties as long as their total fair market value does not exceed 200% of the relinquished property’s value.

The final phase is acquiring the replacement property. The deadline to acquire the new property is the earlier of 180 days from the sale of the relinquished property, or the due date of the partner’s tax return for that year, including extensions. For sales late in the year, this can shorten the exchange period if a tax filing extension is not obtained. The exchanging partner directs the QI to use the held funds to purchase one or more of the identified properties, and the title is deeded directly to the partner to complete the swap.

The exchange must be reported to the IRS by filing Form 8824, Like-Kind Exchanges, with the partner’s federal income tax return for the year of the sale. This form details the properties exchanged, calculates the amount of gain being deferred, and establishes the cost basis of the newly acquired property. Filing this form officially notifies the IRS that a 1031 exchange was performed and the gain is being deferred.