Drop and Swap

A drop and swap is a technique used when real estate is held inside a partnership or multi-member LLC but the individual owners want to go separate ways at the time of a 1031 exchange, with some preferring to cash out and others wanting to defer. Because a partnership interest is not like-kind property and cannot itself be exchanged under Section 1031, the partnership first distributes the underlying real property to its members as tenants-in-common interests, the "drop," converting each owner's partnership interest into a direct, undivided interest in the real estate. Each owner can then independently "swap" their tenancy-in-common interest in a 1031 exchange or sell it for cash, according to their own preference. The principal tax risk is the holding-period and intent question: the IRS may argue the property was not "held for investment" by the individual long enough after the drop, since Section 1031 requires the relinquished property to be held for investment or business use, and a drop executed immediately before the sale can invite scrutiny. Practitioners generally recommend establishing the tenancy-in-common ownership well in advance of the sale and documenting investment intent. Drop-and-swap planning is fact-specific and should always be handled with experienced tax counsel.