Two partners buy a building together in 2009. For fifteen years it works beautifully. Then it stops working, not because the building changed, but because they did. One is ready to cash out and be done. The other wants to keep deferring and roll into the next deal. They agree on exactly one thing: it is time to sell.
And that is where they hit a wall neither of them saw coming.
The wall: a partnership interest is not real estate
Here is the rule that trips them up. A 1031 exchange defers gain for the taxpayer who sells the property and reinvests. When two people own a building through an LLC or partnership, the partnership is that taxpayer, not the individuals. So if the partnership sells and runs a 1031, every dollar has to roll into new real estate held by the partnership. The partner who wants cash cannot pull his share out without triggering tax, and the partner who wants to exchange cannot force her partner to stay invested alongside her.
Their instinct is to say, "fine, we'll each just do our own 1031 on our half." They can't. What each of them owns is a partnership interest, and the tax code specifically excludes partnership interests from 1031 treatment. They own a slice of an entity, not a slice of real estate, and only real estate exchanges.
The maneuver: drop, then swap
The common solution has an inelegant name and an elegant logic. It is called a drop and swap.
- The drop. Before the sale, the partnership distributes the real property out to the individual partners as tenants-in-common interests. Each former partner now directly owns a fractional interest in the actual real estate, rather than an interest in the entity.
- The swap. Now that each person owns real property in their own right, they can each do whatever they like, independently. The partner who wants cash sells his tenants-in-common interest and pays his tax. The partner who wants to defer runs a 1031 exchange on her interest, into a replacement property or a DST. Same building, same closing, two completely different tax outcomes, each chosen by the person it belongs to.
The catch: timing is the whole game
If drop and swap sounds too clean, here is the friction. To run a valid 1031, you must have held the property for investment. When the partnership distributes interests on the courthouse steps the week before closing, the IRS can argue the new tenants-in-common owners never really held for investment at all, and that the whole thing was just the partnership's sale in disguise. This is where these deals are won or lost.
The defense is time and intent. The longer the gap between the drop and the sale, the stronger the position. A distribution done well before a sale is even on the table looks like what it is, real owners holding real property. One done days before closing invites exactly the scrutiny you want to avoid. There are variations on the sequence, and there is real nuance in the documentation, which is why this is genuinely a conversation for your CPA and a tax attorney, not a maneuver to improvise at the closing table.
The real lesson
The partners in our story could still be rescued, depending on how much runway they have before they sell. But the cleaner version of this story is the one where they had the conversation years earlier, ideally before they ever bought together: what happens when one of us wants out and the other doesn't? Mapping partner exits is part of how we plan an exchange from the start, precisely so nobody discovers the wall at the worst possible moment. Your CPA and attorney determine how these rules apply to your partnership.
Questions partners ask us
Can each partner in an LLC do their own separate 1031 exchange?
No. The partnership owns the real estate and is the taxpayer, and individual partnership interests are excluded from 1031 treatment. Partners cannot each exchange their share without first changing how the property is owned.
What exactly is a drop and swap?
The partnership "drops" the property to the partners as tenants-in-common interests, then each owner "swaps" independently, exchanging their interest in a 1031 or selling it for cash. It lets partners take different paths from the same sale.
Is a drop and swap allowed by the IRS?
It is a common and widely used structure, but it is scrutinized, and the timing between the distribution and the sale matters a great deal. It should always be executed with a CPA and tax attorney, not improvised.
How long before a sale should the drop happen?
The longer the better. A distribution done well ahead of any planned sale is far more defensible than one done days before closing, which can look like the partnership's sale in disguise.
What if one partner wants cash and the other wants to exchange?
That is the classic situation a drop and swap solves. Once each owns a tenants-in-common interest directly, one can sell and pay the tax while the other defers through a 1031 exchange.