When partners disagree about selling, one wants cash and another wants to keep deferring. Swap and drop, and its mirror image drop and swap, are ways to split those goals using section 1031 and section 731. Both work on paper, and both draw IRS and FTB scrutiny when done in a hurry.

The Problem: Misaligned Exit Goals

Partners often clash when it is time to sell a property. You might face this common scenario:

  • Partner A: Wants cash now and is willing to pay tax on their share.
  • Partner B: Wants to defer taxes through a §1031 exchange and keep holding real estate.

A standard partnership sale forces everyone to take cash, triggering tax for all partners.

The Swap-and-Drop Structure

Step 1 — The Swap (Exchange First) The partnership completes a §1031 exchange through a qualified intermediary. Your partnership now holds the new replacement property.

Step 2 — The Drop (Distribute to TIC) The partnership distributes the replacement property to partners as tenants-in-common (TIC) interests under §731. Each partner now owns a specific, proportionate share of the replacement property.

Step 3: What happens next A partner who sells their TIC interest soon after the distribution pays tax on that sale. The bigger risk is that the IRS or FTB argues the partnership never held the replacement property for investment, because it planned to distribute it right away. That can undo the partnership's exchange for everyone. How long to hold before and after the drop is a judgment call, and there's no bright-line rule.

Why This Works: §731 Non-Recognition

§731 allows partners to receive property in a liquidation without triggering immediate gain. Each partner takes a substituted basis in their TIC interest equal to their outside basis.

Critical Requirements

  1. Both orders carry risk: The more common structure for a partner who wants cash is "drop and swap." The partnership distributes TIC interests first, and each partner then sells or exchanges on their own. The IRS and the California FTB challenge both orders when the steps happen close together. The FTB has been especially active on drop and swap. The safest versions put real time and real ownership conduct between the steps.
  2. Business purpose: Your liquidation must serve a clear business purpose beyond simply avoiding taxes.
  3. Rev. Proc. 2002-22: This sets the conditions under which the IRS will consider a ruling request that a co-ownership isn't a partnership. It's ruling guidance, not a safe harbor. Tracking its main features, like limits on shared management and each owner's right to sell, lowers the risk that the TIC is treated as a partnership. Partnership interests can't be exchanged under section 1031.
  4. Timing: There's no safe order. Plan the holding periods before and after each step with your CPA and attorney, and document why each step was taken.

Stuck in a partnership with misaligned goals? Let's design an exit. Call LaviCPA →