Drop and Swap: When Partners Want Out in Different Directions

Partnerships that buy property together usually start with the same plan. Twenty years later, one partner wants to retire and take cash, another wants to keep deferring tax and roll into something new, and a third has died and left an interest to children who want nothing to do with real estate.

The property is ready to sell. The partners are not ready to agree. And a quirk of the tax code means neither the cash partner nor the deferring partner can easily get what they want.

Why can a partnership not simply split the exchange?

Because a 1031 exchange is done by the taxpayer that owns the property, and when property is held in a partnership or a multi member LLC taxed as a partnership, that taxpayer is the partnership.

The partnership can exchange the whole property, in which case everyone stays in, including the partner who wanted cash. Or it can sell, in which case the gain is recognised and flows through to every partner, including the one who wanted to defer.

The obvious alternative, where a partner exchanges their partnership interest for real estate, is not available. Partnership interests are specifically excluded from 1031 treatment. You cannot exchange your share of the LLC. You can only exchange real property.

What is a drop and swap?

A restructuring that converts partners from members of a partnership into direct co owners of the property, so each can then decide individually.

The drop. The partnership distributes the property to its partners as tenancy in common interests. Instead of each owning a percentage of an LLC that owns a building, each now owns an undivided percentage of the building directly.

The swap. At sale, each co owner is now a separate taxpayer for exchange purposes. The partner who wants cash takes their share of the proceeds and pays tax. The partner who wants to defer sends their share to a Qualified Intermediary and completes their own exchange.

It solves the problem neatly on paper. The difficulty is what happens under scrutiny.

What is the risk?

The core requirement of a 1031 exchange is that the relinquished property was held for investment or for productive use in a trade or business by the taxpayer doing the exchange.

If the drop happens immediately before the sale, the IRS can argue that the new co owner never held the property for investment at all. They received it one week and sold it the next. The partnership held it, and the partnership sold it. Treated that way, the individual exchange fails.

The IRS can also apply the step transaction doctrine, looking through a series of formal steps to the substance. If the substance is a partnership sale dressed up as individual sales, the dressing may be ignored.

How do people reduce that risk?

Drop early. The longer the partners hold their tenancy in common interests before a sale, the stronger the case that each held the property for investment in their own right. Advisers commonly suggest a meaningful period, often cited as one to two years, though there is no bright line in the code.

Act like co owners. A tenancy in common that is still run exactly like a partnership, with a partnership bank account and partnership returns, looks like a partnership. Separate accounting, a proper co ownership agreement and individual reporting help.

Consider swap and drop instead. The partnership exchanges the whole property first, then distributes interests in the replacement property later. This shifts the holding period problem to the other side of the transaction, and it has its own risks, but it can suit some situations better.

Buy out the leaving partner before the sale. Sometimes the cleanest answer is for the partnership to redeem the partner who wants cash, using a separate arrangement, so the remaining partners can exchange together.

Why do tenancy in common interests complicate lending?

Lenders dislike properties owned by many separate individuals. Existing loans may contain clauses that treat the distribution itself as a transfer requiring consent. Refinancing into co ownership is harder than refinancing a single entity.

Before any drop, read the existing loan documents and speak to the lender. A restructuring that triggers a loan default is a worse problem than the one it set out to solve.

What about a partner who has died?

This situation is more common than people expect, and it often changes the answer.

When a partner dies, their heirs may receive a step up in basis on the inherited interest. Depending on how the partnership is structured and whether an election is made to adjust the basis of partnership property, the heirs may be able to sell their share with little or no gain. For them, an exchange may be unnecessary, and a straightforward buyout or sale can be the simplest route.

That can make the whole exit easier. The heirs take cash with little tax, and the surviving partners who want to keep deferring can then exchange the rest. The details depend heavily on the partnership agreement and on elections made after the death, so this is one to model with a CPA before assuming anything.

What does a well planned exit look like?

The partnerships that handle this well tend to follow a similar pattern.

• ›They agree the exit strategy years before the sale, not months
• ›Each partner states a goal in writing: cash, deferral or estate planning
• ›If a drop is chosen, it happens early and the co owners operate separately afterwards
• ›Loans and lender consents are addressed before any restructuring
• ›The Qualified Intermediary is engaged for each exchanging co owner well before closing

None of this is complicated individually. The difficulty is that it all takes time, and partnership disagreements tend to surface only when an offer is already on the table.

What to do first

If partners are already disagreeing about the exit, start the conversation years before the sale rather than months. Bring in a CPA and an attorney who handle partnership exchanges regularly, map each partner's goal, and choose a structure with enough time to be defensible.

The worst outcome is a rushed drop a few weeks before closing, which combines all of the complexity with little of the protection.

Nothing here is tax, legal or investment advice. Partnership restructuring is highly fact specific. Confirm any plan with your CPA and attorney before acting.