Drop and Swap vs. Swap and Drop: What Co-Owners Need to Know Before a 1031 Exchange

Three investors. One property. Three different goals.

John, Mary and Bob own an investment property together. They’ve owned it for years, the property has appreciated substantially, and they’re ready to sell. But they don’t agree on what they want to do next.

John wants to take the cash and move on. Mary wants to buy another investment property and continue managing real estate. Bob wants to remain invested in real estate, but prefers a passive investment instead.

They all own the same property. They just have different goals for what happens next.

Here’s the Problem

In a deferred 1031 exchange, you sell an investment property first and then acquire replacement property. But what happens when several people own the property together?

The answer depends on who owns the real estate and how it is owned.

Suppose John, Mary and Bob own the apartment building through an LLC, partnership, corporation or another ownership structure. The important question isn’t just what the entity is called — it’s who owns the real estate and how that ownership is structured for tax purposes.

For example, if the property is owned through a partnership, the partnership owns the real estate, while the individual owners own interests in the partnership. That distinction matters in a 1031 exchange.

A partnership interest itself is not qualifying real property for Section 1031 purposes. So the three owners can’t simply sell the building and say, “I’ll take my share and do my own 1031.”

That’s where Drop and Swap and Swap and Drop come into the conversation.

Here’s Drop and Swap

Drop first. Swap second.

Before the property is sold, the partnership may distribute the real estate to its owners. The owners may then hold direct, undivided interests in the real estate, as tenants in common, rather than owning interests in the partnership.

Here’s what changes

That’s the important part. The owners have changed from owning interests in the partnership to holding direct interests in the real estate. An undivided interest in qualifying real property can qualify for a 1031 exchange, while a partnership interest generally cannot.

Now what?

The property is sold. John, Mary and Bob may now have more flexibility in deciding what to do with their individual interests. For example:

• John could take cash.
• Mary could pursue a 1031 exchange into another investment property.
• Bob could consider a qualifying DST as replacement property.

That’s the basic appeal of a Drop and Swap — it can give co-owners more flexibility when their investment goals are no longer the same.

Do Drop and Swaps Actually Work?

Yes, Drop and Swap is a recognized planning approach. But it is not an automatic tax solution.

Section 1031 applies to real property held for investment or productive use in a trade or business. If property is distributed immediately before an already-planned sale, questions can arise about whether the owners actually held their new interests for investment. There is no fixed IRS holding period that automatically makes a Drop and Swap qualify — the facts, timing and circumstances matter.

That’s why this type of planning should be considered well before the property is under contract, rather than at the last minute.

Here’s Swap and Drop

Swap first. Drop second.

Instead of changing the ownership before the sale, the partnership completes the 1031 exchange first. The basic sequence:

1. Partnership sells the property
2. Partnership completes the 1031 exchange
3. Partnership acquires replacement property
4. Ownership may later be restructured, or interests in the replacement property may be distributed

That’s a Swap and Drop.

Why would anyone consider it?

Back to John, Mary and Bob — this time, all three agree that they want to defer their taxes and remain invested in real estate. They sell the apartment building, and the partnership completes a 1031 exchange into replacement property. But after the exchange, they don’t necessarily want to remain partners forever.

A Swap and Drop may be considered when the owners want to complete the exchange together first and address their ownership afterward. The difference is simply the order:

• Drop and Swap: Change ownership → sell → 1031 exchange
• Swap and Drop: Sell → 1031 exchange → consider changing ownership

Can a Swap and Drop Really Be Done?

Yes, it is a recognized planning approach. But it isn’t as simple as completing a 1031 exchange and automatically handing everyone a piece of the replacement property.

The partnership can potentially restructure or distribute the replacement property afterward, but partnership distributions have their own tax rules. The consequences depend on the property, the partners’ interests and the specific circumstances. The replacement property also needs to meet the 1031 requirement that it be held for investment or productive use in a trade or business.

The key is that the ownership change happens after the partnership completes the exchange, rather than before it.

Drop and Swap vs. Swap and Drop

Here’s the easiest way to remember the difference:

Which approach may make more sense?

Neither is automatically better.

Drop and Swap may make more sense when the owners have different plans for the sale — one may want cash, another may want a different investment property, and another may want a passive investment such as a DST. Moving to direct ownership before the sale can give each owner more flexibility to pursue a different outcome.

Swap and Drop may make more sense when the owners are willing to complete the 1031 exchange together first. The partnership remains together through the exchange, and the ownership issue is addressed afterward.

The trade-off is timing. A Drop and Swap raises questions about the owners’ intent and holding of their direct interests before the sale. A Swap and Drop shifts those ownership questions to the period after the partnership acquires the replacement property.

Does the Ownership Structure Matter?

Yes, but don’t let the name of the entity confuse you.

Drop and Swap and Swap and Drop are most commonly discussed when investment real estate is owned through a partnership or an LLC taxed as a partnership. An LLC can be taxed in different ways, while corporations and S corporations have different ownership and tax rules.

If an LLC is taxed as a partnership, the partnership issues discussed in this article can apply.

If a corporation owns the property, the corporation owns the real estate and the shareholders own shares of the corporation. The corporation — not the individual shareholders — is the owner of the real estate for purposes of the exchange. A shareholder cannot simply take a portion of the corporation’s sale proceeds and do an individual 1031 exchange. An S corporation is still a corporation for this purpose.

The important question is who owns the real estate and how that ownership is treated for tax purposes. If your property is owned through an LLC or corporation, understand the ownership and tax structure before deciding how to approach a 1031 exchange.

Here’s Where a DST Can Fit

Now let’s go back to John, Mary and Bob. Suppose they have worked through their ownership issue and can each pursue their own investment strategy. Mary wants another investment property. Bob wants something more passive.

That’s where a Delaware Statutory Trust, or DST, may become an option.

The IRS addressed qualifying DST structures in Revenue Ruling 2004-86. Under the facts of that ruling, an interest in the DST was treated as an interest in the underlying real property for federal tax purposes and could qualify as replacement property in a Section 1031 exchange.

For an investor who doesn’t want to purchase and manage another property directly, a DST can provide a way to remain invested in real estate without taking on day-to-day property management.

So our three investors could potentially have three different paths:

• John: Takes cash.
• Mary: Exchanges into another investment property.
• Bob: Considers a qualifying DST.

That’s why these strategies can be worth understanding — the owners don’t necessarily have to make the same investment decision.

What Should Co-Owners Do First?

Start well before you decide to sell.

If you own investment real estate with partners, family members or other investors, don’t wait until the property is on the market to figure out what everyone wants to do. Start with these questions:

• Who owns the property?
• How is it taxed?
• Who wants cash?
• Who wants to continue investing?
• Who wants a passive investment?
• What does each owner want to do when the property is sold?

Those answers can help determine whether Drop and Swap, Swap and Drop, a direct 1031 exchange or another approach is worth exploring.

A tax adviser and legal counsel should evaluate the specific ownership structure and transaction before any ownership changes are made.

The Bottom Line

A 1031 exchange can be relatively straightforward when everyone wants the same thing. When co-owners want different outcomes, the right approach may depend on how the property is owned and what each owner wants to do next.

Drop and Swap may provide more flexibility when owners want different outcomes. Swap and Drop may be considered when the owners are willing to complete the exchange together and address their ownership afterward.

If you own investment real estate with other people, start the conversation well before you decide to sell. Knowing what each owner wants to do can make a significant difference in how you approach the property and any potential 1031 exchange.

This material is provided for general informational purposes only and is not tax, legal, or investment advice. 1031 exchanges and DST investments involve complex rules and specific requirements. The tax treatment of any transaction depends on the individual facts and circumstances. Investors should consult their tax adviser and legal counsel before making decisions regarding a 1031 exchange or changing ownership of real estate.