Drop-and-Swap and Swap-and-Drop: 1031 Strategies for Splitting Up a Partnership

What a drop actually is: deeds to each partner, a co-ownership agreement and, usually, a final Form 1065

The drop is a distribution of the real estate itself. The operating agreement is amended to permit in-kind distributions, the entity deeds an undivided percentage to each partner or to a single-member LLC each partner owns, the deeds are recorded, and the former partners sign a tenancy-in-common agreement. A single-member LLC is ignored for tax purposes under Reg. §301.7701-3(b)(1)(ii), which is why the IRS accepted them as the recipients in PLR 202416012.

If every partner leaves, the partnership terminates under §708(b)(1) because no business ‘continues to be carried on by any of its partners in a partnership’, and the group files a final Form 1065. From then on each co-owner reports his or her share of rent and expenses on their own return, which is the evidence that separate taxpayers now own the property.

The swap-and-drop reverses the order: the entity exchanges, and only later deeds undivided interests in the replacement out to the partners. Asset Preservation notes that the taxpayer prevailed in Magneson when an individual exchanged and ‘immediately’ contributed the replacement to a partnership, and that the Ninth Circuit framed the question as whether property contributed under §721 is ‘held’ for investment (Magneson v. Commissioner).

The authorities line up on one question: was the distribution independent of the exchange?

The IRS’s rulings go against the taxpayer when the steps are one plan. In Rev. Rul. 77-337 a shareholder liquidated his corporation and, ‘immediately following the liquidation, in a prearranged plan’, exchanged the shopping centre; the Service held the corporation’s prior use ‘cannot be attributed’ to him, restating Rev. Rul. 75-292, where an exchanger dropped the replacement into a new corporation right away.

The courts have been kinder. Bolker, the sole shareholder of the Crosby Corporation, won in the Ninth Circuit on nearly the same liquidation facts (Bolker v. Commissioner, 760 F.2d 1039), and Asset Preservation cites ‘Bolker, Mason, Maloney, etc.’ as ‘taxpayer-friendly authority against challenges by the IRS’. The loss to study is Chase v. Commissioner, where the Tax Court concluded that ‘in substance, the partnership in which petitioners were partners, disposed’ of the property, so the partners’ own exchanges failed.

The freshest signal is PLR 202416012: a testamentary trust’s mandatory termination distributed undivided interests to beneficiaries after a sales contract was signed, and the IRS ruled the distribution ‘will be wholly independent of Taxpayer’s Proposed Exchange’ and distinguishable from ‘voluntary transfers of properties pursuant to prearranged plans’. Legal 1031 adds that Field Service Advice 199951004 told agents that investment-intent challenges to drop-and-swaps ‘have not held up well in litigation’.

The timing ladder: two years, one year, a few months, and after the contract

No statute or regulation sets a holding period between a drop and a sale, so the rungs below are practitioner judgement about audit risk, not rules. Use them with your CPA and tax attorney, who will weigh the state you are in as heavily as the calendar.

• Two years or more of separate ownership, separate reporting and no buyer in sight: the strongest position, because every fact that mattered in Chase points the other way.
• About one year: the interval many intermediaries treat as prudent; 1031 Crowdfunding reports practitioners citing ‘12-month or 24-month intervals’, and Equity Advantage tells clients to convert ‘at least one year in advance or during escrow’.
• Months before listing, with no letter of intent: PLR 202416012 and the 2025 New York decision in Hadar suggest that independence and documentation matter more than length, and Legal 1031 concludes that a challenge ‘based solely on the exchanger holding real estate for a short period, is likely a thing of the past’.
• After a signed contract: the Court Holding fact pattern, which Asset Preservation says ‘depends on whether the partnership has agreed to sell the property before the drop occurs’; Legal 1031 reports California ‘continues to challenge’ exactly this sequence.
• Same day as closing: Hadar won in New York on ‘long-held investment intent’, but that ruling ‘applies only to New York State and does not bind the IRS or other state taxing authorities’.

The §761(a) election: when co-owners who never ran a business can stop being a partnership

§761(a) lets an unincorporated organisation used ‘for investment purposes only and not for the active conduct of a business’ elect out of subchapter K if the members’ income ‘may be adequately determined without the computation of partnership taxable income’. Once the election is in effect, Reg. §1.1031(a)-3(a)(5)(i) treats the interests as real property and each member can exchange.

Reg. §1.761-2(a)(2) sets three conditions: the members own the property as co-owners, each reserves ‘the right separately to take or dispose of their shares’, and none has irrevocably authorised an agent to buy, sell or exchange for more than a year. The election is made in a statement attached to a timely Form 1065, or is deemed made when the members reported as co-owners from the start.

The election fits a group that holds a net-leased building or land and has been filing Form 1065 out of habit. It does not fit a partnership that operates the property with services to tenants, and it does not undo years of partnership returns overnight.

Already under contract? Use the entity’s exchange, an installment note or a later swap-and-drop instead of a rushed deed

A distribution deeded days before a closing that was negotiated months earlier is the transaction Chase and Court Holding describe, so once the entity has agreed to sell, keep the entity as the seller. Let it exchange the whole property and solve the partner problem afterwards or through the consideration it receives.

For a partner who wants out, the entity can take part of the price as a buyer’s note and distribute that note to him, which is the partnership installment note covered on its own page, or it can complete the exchange and redeem him later from a refinance. For partners who want separate properties, the swap-and-drop distributes undivided interests in the replacement after a real holding period, accepting that Form 1065 Question 11 will flag a distribution within the current or the preceding tax year.

The one thing not to do is close the sale in the entity’s name, hand members their shares of the proceeds and let each buy a replacement; Legal 1031 states that individual partners ‘cannot simply take their share of the cash and transact separate exchanges’.

Reporting the split: answer Questions 11 and 12 truthfully, file Form 7217 and Form 8824, and watch the seven-year rules

The Form 1065 instructions require a ‘Yes’ to Question 12 whenever the partnership ‘distributed property to its partners to be jointly owned’, and their example is a partnership that ‘converts its title to the land to fractional interests in the name of the partners’. Question 11 must be checked if the partnership ‘engaged in a like-kind exchange during the current or immediately preceding tax year and received replacement property that it distributed’.

Each partner who receives property files Form 7217 with that year’s return, ‘a separate Form 7217 for each date’ property was received, to report the basis taken under §732. Every co-owner who then exchanges files his or her own Form 8824, and the Form 8824 instructions restate that partnership interests, apart from a §761(a) partnership, are not real property.

Before any drop, check whether the building or any capital was contributed within the past seven years: §704(c)(1)(B) taxes the contributing partner when contributed property goes to another partner inside that window, and §737 taxes a partner who receives other property while holding ‘net precontribution gain’.