Selling With Partners? Fix the Ownership Before You List
The most common way a 1031 exchange fails has nothing to do with the 45-day clock. It happens months earlier, on the deed.
This article is general education, not legal or tax advice. The rules discussed are fact-specific and vary by state. Consult your own attorney and CPA before changing how title is held.
Here is a conversation I have had more times than I can count. Two siblings, or three business partners, or a married couple and a friend, own a building through an LLC they set up fifteen years ago. The building is worth several million dollars more than they paid. One of them wants to sell and retire. One wants to sell and buy something bigger. One wants to keep it. They have a buyer. They call to ask about a 1031 exchange.
And the answer is: it depends on a question they have never thought about, which is who, exactly, is the taxpayer?
The same-taxpayer rule
Section 1031 defers gain when a taxpayer exchanges real property for other real property. The taxpayer that sells must be the taxpayer that buys. If Smith Properties LLC sells the building, Smith Properties LLC must acquire the replacement — not the members individually. If the members each want to go a separate direction, the LLC cannot do three exchanges on their behalf. It is one taxpayer with one exchange.
This is where the partners discover that their LLC, which was a sensible liability shield for fifteen years, has become a tax problem. The partner who wants to keep the building cannot be bought out with exchange proceeds without the others recognizing gain. The partner who wants a DST cannot exchange her one-third share, because she does not own real estate — she owns an LLC interest, and partnership interests are specifically excluded from 1031 treatment.
The “drop and swap”
The standard solution has a plain-English name. The LLC distributes the property to its members as tenants in common — that is the drop — so that each member holds a direct, undivided interest in the real estate. Each member then sells his or her interest and does (or does not do) an exchange individually — the swap. One partner takes cash and pays the tax. One exchanges into a larger building. One exchanges into a DST. Everyone gets what they wanted.
It works, and it is done every day. It also carries a risk that comes down to one word: timing. The IRS position is that property must be held for investment — not acquired for the purpose of immediately exchanging it. If the LLC distributes the property to the members on Monday and the members sell on Tuesday, an examiner can argue the members never held the property for investment at all; they held it to sell. Several court decisions have allowed drop-and-swaps on short timelines, and several state agencies — California’s in particular — have been aggressive in questioning them. The partnership tax return now asks directly about like-kind exchanges and property distributions, so the transaction is visible to an examiner.
The practical guidance most practitioners give is simple: do the drop well before you have a buyer, ideally before you list, and document a genuine investment intent — hold the tenancy-in-common interests, collect rent under them, file accordingly — for as long as circumstances allow. The longer the interval, the stronger the position. A drop the week before closing is the version that gets challenged.
Tenancy in common done properly
Once the members hold as tenants in common, they are no longer partners for tax purposes — if the arrangement is structured so. The IRS published guidance in 2002 setting out conditions under which co-owners of real estate will be treated as owning real property directly rather than as partners: a limited number of co-owners, unanimous consent on major decisions, sharing of income and expenses in proportion to ownership, no business activity beyond customary property operations, and so on. A tenancy-in-common agreement drafted to those conditions is what makes the individual exchanges defensible. A tenancy in common that keeps operating exactly like the old partnership — one member making all the decisions, income split by some other formula — invites the argument that nothing really changed.
The alternatives
The drop and swap is not the only route, and it is not always the best one.
- The entity exchanges, then distributes later. The LLC does one exchange into the replacement property and, after a genuine holding period, distributes interests or redeems the departing partner. Simpler at the front end; the partner who wanted out waits.
- Swap and drop. The reverse order: the LLC completes the exchange into replacement property first, then distributes tenancy-in-common interests to the members. The same holding-period scrutiny applies, in mirror image.
- Buy out the departing partner before the sale. The remaining members purchase the exiting member’s interest with their own funds, leaving a single-minded LLC to do a clean exchange. Works when the others have the cash and the departing partner is content to recognize gain on the interest.
- Do nothing and pay the tax. Sometimes the cleanest answer. A partner with a modest gain, a high basis, or a plan to spend the money may be better off with a taxable sale than with a structure built to avoid one.
The DST angle
Where a DST fits: the partner who wants passive income and no more management can exchange his tenancy-in-common interest into a DST, because a DST beneficial interest is treated as direct ownership of real estate for 1031 purposes under a 2004 IRS ruling. He gets the deferral; his former partners get their own outcomes; nobody has to agree on the same replacement property. That flexibility is the reason DSTs and drop-and-swaps so often appear in the same transaction. It is also why the drop has to be done right — a DST cannot fix a defective exchange upstream of it.
What to do now
- If you own investment property with anyone else through an entity, find out how title is held and what your operating agreement says about distributions. Do it this year, not the year you sell.
- Have a frank conversation with your co-owners about what each of you wants at exit. Different answers are normal; surprising each other at closing is expensive.
- Bring your attorney and CPA in before you list, and have them coordinate with a qualified intermediary early.
- Whatever restructuring you do, do it early and document the intent.
The 45-day clock gets all the attention. The exchanges I have seen fail did not run out of time. They ran out of options because a decision made years earlier — how to hold title — was never revisited before the sale.
Own property with partners and thinking about a sale? Talk it through with our team. We will help you and your advisors map the options before the clock starts.
Sources: Internal Revenue Code §1031 and Treasury Regulations §1.1031; Revenue Procedure 2002-22; Revenue Ruling 2004-86; IRS Form 1065, Schedule B; relevant Tax Court and appellate decisions on drop-and-swap transactions. General education only; not legal advice.
Michael brings more than twenty-five years as a real estate attorney, investor, and developer to helping clients structure 1031 exchanges. Full profile →
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