Avoid IRS surprises in “drop and swap” 1031 deals. Learn the key risks: taxpayer continuity, deemed partnership, and holding period.
Real estate partnerships often start with aligned goals: a business plan, a desired hold period, and a shared exit strategy. As assets mature and personal circumstances change, those goals can drift.
One partner may be ready to cash out for liquidity, retirement, or estate planning, while another wants to stay invested and defer gain through a Section 1031 exchange.
When those priorities diverge, “getting to yes” on a sale can become the moment the partnership model starts to unwind.
Drop and swap: A common fix with common pitfalls
A structure frequently proposed to accommodate those competing outcomes is the “drop and swap.”
In general terms, the partnership distributes undivided interests in the real property to the partners (so each holds title as a tenant in common, or TIC). The partners then pursue separate transactions, with some completing individual Section 1031 exchanges into replacement property while others sell for cash.
Because this approach changes ownership immediately before a disposition, it often draws heightened IRS scrutiny.
In many examinations, the IRS treats a drop and swap as part of the sale transaction and applies statutory requirements and long-standing case law to determine whether the partnership should be treated as the seller. That outcome can convert an intended deferral strategy into a taxable sale at the partnership level.
Continuity of taxpayer
Section 1031 requires continuity of taxpayer. The party disposing of the relinquished property must be the same party acquiring the replacement property. When a partnership distributes deeds to its partners shortly before a sale, ownership shifts from a legal entity to individual taxpayers.
If the distribution occurs after a buyer has been identified or after a letter of intent has been executed, the IRS often relies on the Court Holding doctrine. Under this framework, the IRS takes the position that the partnership remained the true seller and that the individual partners functioned only as conduits.
The partnership sold the property, while different taxpayers attempted to acquire replacement property. The exchange fails under this analysis, and the partners are treated as having received taxable distributions rather than exchange proceeds.
The deemed partnership risk
A successful exchange also depends on whether post-distribution ownership reflects a true co-tenancy and supports separate ownership in practice.
The IRS is permitted to reclassify a tenant-in-common arrangement as a partnership when owners continue to operate as joint business partners. Common indicators include a shared operating bank account, centralized sharing of profits and losses, or a property manager with authority to act without unanimous owner consent.
When a co-tenancy is reclassified as a partnership, the exchange collapses. Section 1031(a)(2) excludes partnership interests from eligibility. In attempting to simplify ongoing operations, owners often reconstruct the same partnership structure they intended to unwind, with direct implications for exchange treatment.
Investment intent and holding period
Tax deferral under Section 1031 also depends on investment intent. Each exchanger must demonstrate that the relinquished property was held for investment. When a partner receives a deed shortly before sale, the IRS evaluates intent based on timing, documentation, and surrounding facts.
A brief holding period offers limited support for an investment purpose. Transactions that reflect meaningful ownership and cover multiple tax years generally carry stronger support. Absent that evidence, the IRS often characterizes the transfer as a step undertaken to facilitate a sale, resulting in immediate gain recognition.
How CLA can help
Section 1031 planning works best with early coordination, often before a property is marketed or a buyer is identified. Effective execution typically involves a qualified intermediary along with transaction-level tax planning grounded in audit experience and an understanding of how the IRS analyzes step transactions, intent, and entity classification.
Our real estate tax team can help you:
- Structure pre-sale distributions to support defensible investment intent and holding periods
- Evaluate TIC agreements consistent with Revenue Procedure 2002-22 and co-tenancy treatment
- Assess “continuity of taxpayer” and step-transaction risk based on deal timing
- Model tax outcomes for both exiting and exchanging partners to support informed decision-making