Drop and Swap 1031: Exchanging Out of a Partnership or LLC

A drop and swap lets partners who want different outcomes go separate ways: the partnership distributes the real estate to partners as tenancy-in-common (TIC) interests, the “drop,” and each partner then sells or exchanges its own share, the “swap.” It exists because a partnership interest can’t be exchanged under §1031, and the main risk is that the partner didn’t “hold” its TIC interest for investment before the sale.

Why partnership interests are excluded

Since 2018, §1031(a) covers only real property held for business or investment. Reg. §1.1031(a)-3(a)(5) lists “interests in a partnership” among the intangibles that are not real property for §1031, “regardless of the classification of such property under State or local law.” §1031(e) carves out one case: a partnership with a valid §761(a) election out of subchapter K is treated as owning its assets directly. An LLC with two or more members is a partnership by default (Reg. §301.7701-3(b)(1)), so a multi-member LLC that owns real estate falls under the same rule unless it has elected to be taxed as a corporation (and corporate stock doesn’t qualify either).

That leaves three options when partners want different outcomes. The partnership can exchange and everyone stays in. The partnership can sell and everyone pays tax. Or the property comes out of the partnership first.

How the drop and swap works

1. The partnership deeds undivided TIC interests in the property to the partners who want to exchange. Partners who want cash may be redeemed with a TIC interest too, or stay in the partnership, which sells its remaining share.
2. Each TIC owner, now holding real estate directly, signs its own exchange agreement with a qualified intermediary and assigns its share of the sale contract.
3. At closing, each co-owner sells its undivided interest. The exchangers’ proceeds go to their QIs. Anyone cashing out pays tax on their share.
4. Each exchanger identifies replacement property within 45 days and closes within 180, on its own clock.

The timing of step 1 relative to the sale is what gets examined.

The holding risk

The IRS has two lines of attack, and they overlap.

The partnership was the real seller. If the partnership negotiated the sale and the distribution was a formality, the step-transaction and substance-over-form doctrines can treat the partnership as having sold the property and distributed cash. The Supreme Court’s decision in Commissioner v. Court Holding Co., 324 U.S. 331 (1945), is the standard citation for asking who, in substance, made a sale.

The partner didn’t hold the property for investment. In Rev. Rul. 77-337, as the Ninth Circuit summarized it in Bolker (below), a shareholder liquidated his corporation to get a shopping center “so that he could immediately exchange it,” and the IRS ruled that he never held the property and §1031 didn’t apply.

Two Ninth Circuit cases from 1985 went the other way on their facts:

• Bolker v. Commissioner, 760 F.2d 1039 (9th Cir. 1985). Bolker liquidated his wholly owned corporation and took the property. The same day, he contracted to exchange it; the exchange closed three months later. The court held he held the property for investment. It distinguished Rev. Rul. 77-337 on two facts: the liquidation was planned before any intent to exchange, and Bolker “did actually hold” the property for three months. Reading the statute’s plain words, the court said a taxpayer meets the holding requirement “by owning the property” and meets the investment requirement by lacking intent “either to liquidate the investment or to use it for personal pursuits.”
• Magneson v. Commissioner, 753 F.2d 1490 (9th Cir. 1985). The reverse sequence: the Magnesons exchanged for a TIC interest and contributed it to a partnership the same day. The court held they had held the property for investment: they “continue to hold for investment, albeit in a different form of ownership.” In Bolker, the same court described Magneson as resting on the contribution being “a change in the form of ownership rather than the relinquishment of ownership.”

Both are Ninth Circuit decisions that turned on intent and continuity of investment. Neither sets a minimum holding period, and §1031 and its regulations don’t either.

Rev. Proc. 2002-22: TIC guidelines, not a safe harbor

The partners hold the property as co-owners after the drop, and a co-ownership can itself be a partnership for tax purposes if it acts like one. Rev. Proc. 2002-22 lists the conditions under which the IRS will consider a private letter ruling that a TIC interest in rental real property is not an interest in a business entity. It says its guidelines “are not intended to be substantive rules and are not to be used for audit purposes.” So meeting them doesn’t guarantee anything without a ruling; they describe what the IRS looks at.

Some of the 15 conditions in section 6:

Condition	What it requires
6.01 Title	Each co-owner holds title as a tenant in common under local law (directly or through a disregarded entity)
6.02 Number	No more than 35 co-owners, with spouses counted as one
6.03 No entity treatment	No partnership return, no common business name, no holding out as partners
6.05 Voting	Unanimous approval to sell, lease, refinance a blanket lien or hire a manager
6.06 Alienation	Each co-owner can transfer, partition and encumber its interest, subject to customary lender restrictions
6.12 Management	Agreements renewable no less often than annually; net revenues disbursed within 3 months

One sentence in 6.03 bears directly on drop and swaps: the IRS “generally will not issue a ruling” if the co-owners held their interests through a partnership “immediately prior to the formation of the co-ownership,” which describes every drop and swap.

California’s view

California’s Franchise Tax Board has challenged drop and swaps. In the Appeal of S. Mitchell, OTA Case No. 18011715 (Office of Tax Appeals, issued August 2, 2018), a general partnership whose only asset was a Walnut Creek building distributed TIC interests to two partners, the appellant and her mother, who wanted to stay invested in real estate. The deed to them was recorded November 29, 2007. The deed conveying the property to the buyers was recorded the next day. The FTB argued the partnership, not the partner, sold the property, and proposed $60,209 of additional tax.

The OTA reversed the FTB 2 to 1 and held the exchange valid. One judge dissented, finding that only the partnership negotiated the sale. The decision is marked “Nonprecedential,” so it doesn’t bind the FTB in other cases. Exchangers with California property also face the state’s annual FTB 3840 filing if they buy outside California; see state 1031 rules.

The swap and drop

The reverse order, exchange first and then contribute the replacement property to a partnership or LLC, is the Magneson fact pattern, which the Ninth Circuit allowed. A related variant has the partnership exchange and then distribute the replacement property to partners. The same holding question applies to the replacement side: §1031 requires replacement property “to be held” for investment, and the courts in both 1985 cases looked at intent at the time of the exchange.

If the partners are related to each other or to the partnership, the 2-year rule in §1031(f) can also apply; see related-party exchanges.

Have a tax attorney review the structure before the partnership distributes anything, including who negotiates the sale and how far apart the deeds record. Ask any QI you interview how many multi-owner exchanges it has run.

Sources

• 26 U.S.C. §1031
• Treas. Reg. §1.1031(a)-3
• Treas. Reg. §301.7701-3
• Bolker v. Commissioner, 760 F.2d 1039 (9th Cir. 1985)
• Magneson v. Commissioner, 753 F.2d 1490 (9th Cir. 1985)
• Rev. Proc. 2002-22 (IRB 2002-14, p. 733)
• Appeal of S. Mitchell, OTA Case No. 18011715 (2018)