Drop and Swap and Other 1031 Exits for Syndications
What a sponsor can do when some investors want to defer gain with a 1031 exchange and others want cash, and the risks each path carries.
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Written for sponsors, GPs and capital raisers. This is educational, not individualized tax advice; your operating agreement, offering documents and facts control how any rule applies to you.
Worked example (illustrative)
A $12,000,000 gain, two groups of investors
A syndication will sell its property for $30,000,000. Its adjusted tax basis is $18,000,000, so the gain is about $12,000,000 (ignoring selling costs and the promote for simplicity). Investors holding 60% of the interests want to defer gain with a 1031 exchange; investors holding 40% want cash. Round, illustrative numbers only.
| Path | Who could defer | Who recognizes gain | Main risk |
|---|---|---|---|
| Partnership sells, no exchange | No one | Everyone: $12,000,000 in total | None beyond the tax itself |
| Partnership exchanges; everyone stays in | All partners, on up to $12,000,000 | Only to the extent of boot | Cash investors are forced to stay in the replacement property |
| Partnership buys out the 40% first, then exchanges | The 60% group, on about $7,200,000 | The 40% group, about $4,800,000 at the buyout | Funding the buyout; timing the redemption against the sale |
| Drop and swap into co-ownership | The 60% group, on about $7,200,000 | The 40% group, about $4,800,000 on their sale | Held-for-investment and step-transaction challenges; lender consent; co-owner limits |
The tax deferred is the same about $7,200,000 under either of the last two paths. What differs is who bears the risk if the structure is challenged, how early the decision must be made, and whether the lender and the investor count even allow it.
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Why Investors Cannot Exchange Their Interests
Only real property qualifies
Since 2018, Section 1031 applies only to real property held for productive use in a trade or business or for investment. An interest in a partnership is not real property under the regulations, so a limited partner cannot sell a syndication interest and exchange into something else. The partnership owns the building, so only the partnership can exchange it, and the same taxpayer that sells must acquire the replacement property.
That is why the exit question is a sponsor question: the sponsor decides whether the partnership exchanges, and whether to restructure ownership before a sale so investors can choose. For the general exchange rules, see our 1031 exchange guide.
Option 1: The Partnership Exchanges
Simplest, least flexible
The partnership sells through a qualified intermediary, identifies replacement property within 45 days and closes within 180 days (or the return due date, if earlier). Every partner stays in and the deferral passes through. Any cash or other boot the partnership receives is taxable, and replacing less debt than it paid off can create boot too; see 1031 boot.
The problem is investor fit. A deal raised as a five-year hold now asks every investor to stay in a new property. Operating agreements rarely address that, so investor consent and the sponsor's fiduciary duties come into play, which are questions for your securities attorney.
Option 2: Buy Out the Cash Investors First
Redeem, then exchange
The partnership redeems the investors who want cash, using reserves, new financing or new capital, and then exchanges the property for the partners who remain. The redeemed partners recognize gain under the partnership distribution and sale rules (IRC 731, 736 and 741), including their share of any depreciation recapture.
Timing is the hard part. A redemption funded from the sale itself, or completed days before closing, invites the argument that the partnership really sold the property and distributed cash. The redemption needs its own funding and its own economics.
Option 3: Drop and Swap (and Swap and Drop)
Flexible, and the most scrutinized
In a drop and swap, the partnership distributes undivided tenancy-in-common interests to some or all partners. Each co-owner then sells its share for cash or completes its own exchange. In a swap and drop, the partnership exchanges first and distributes the replacement property later. Neither is described in the Code or regulations.
The risks
- Held for investment. Section 1031 requires that the relinquished property was held for investment by the person exchanging it. A co-owner who received the property days before the sale has a weak record of holding it. Courts have accepted some restructurings (for example Magneson and Bolker in the Ninth Circuit), but results depend on facts.
- Who really sold. If the partnership negotiated the sale before the drop, the IRS can attribute the sale to the partnership under the Court Holding doctrine, undoing the exchange for every co-owner.
- Co-ownership that is really a partnership. Co-owners who operate the property together like a business can be treated as a partnership. IRS ruling guidelines in Rev. Proc. 2002-22 limit co-owners to 35 and set conditions such as direct title and unanimous approval of major decisions.
- Practical limits. Lender consent, title for every co-owner, and investor counts in the hundreds make a full drop impractical for most large syndications.
Some states watch these closely
State tax agencies have challenged drop and swap structures, and nonresident withholding rules can apply to each co-owner's sale. Plan with the property state in mind.Co-owners who do exchange often look at a Delaware statutory trust as replacement property; see our 1031 exchange into a Delaware statutory trust guide.
A Sponsor Timeline for the Exit Decision
Work backward from the sale
- At the raise: decide whether the operating agreement addresses exchanges, buyouts or in-kind distributions at exit.
- A year or more before a likely sale: survey investor preferences and model each path, including recapture and debt replacement.
- Before marketing the property: complete any restructuring, with lender consent and counsel's sign-off.
- Under contract: engage the qualified intermediary before closing; once proceeds reach the seller, the exchange is lost.
- After closing: track the 45-day and 180-day deadlines and report the exchange on Form 8824.
Exit planning is also where depreciation recapture from a cost segregation study shows up; see cost segregation for syndications.
Frequently Asked Questions
1031 exits for syndications
What is a drop and swap?
A restructuring before a sale in which the partnership distributes undivided tenancy-in-common interests in the property to some or all partners (the drop), and each new co-owner then sells for cash or completes its own 1031 exchange (the swap). It is used when partners in one deal want different exits. It is not described in the Code or regulations, and its main risks are the held-for-investment requirement and the possibility that the IRS treats the partnership as the real seller.
Can a limited partner exchange their syndication interest in a 1031?
No. Section 1031 applies only to real property held for productive use in a trade or business or for investment, and an interest in a partnership is not real property. Only the partnership, as owner of the property, can exchange it, unless the ownership is restructured before the sale.
How long before a sale should a drop and swap happen?
There is no safe harbor period. The longer the former partners hold the property as co-owners before a sale is negotiated, the stronger the argument that they held it for investment and that the sale was theirs rather than the partnership’s. Many advisers prefer the restructuring well before a buyer is in the picture. A drop in the same week as a signed purchase agreement is the highest-risk version.
Does a drop and swap work for a syndication with 150 investors?
Rarely in its full form. Lenders must consent, each co-owner must hold title, and IRS ruling guidelines for tenancy-in-common arrangements limit co-owners to 35 and impose conditions designed to keep the co-ownership from being a partnership. Large syndications more often exchange at the partnership level or buy out a smaller group of partners.
What about investors who want to exchange into a DST?
A Delaware statutory trust can be a replacement property for an investor who owns real property directly, including a former partner after a drop. It does not solve the starting problem that a partnership interest itself cannot be exchanged.
Authoritative Sources
- IRC 1031: Exchange of real property held for productive use or investment, including the 45-day and 180-day periods
- Treas. Reg. 1.1031(a)-3: Definition of real property for Section 1031
- Treas. Reg. 1.1031(k)-1: Deferred exchanges and qualified intermediaries
- IRC 731, 736 and 741: Partnership distributions, payments to retiring partners and sales of interests
- Rev. Proc. 2002-22: Conditions for ruling requests on tenancy-in-common interests (2002-14 I.R.B. 733)
- Treas. Reg. 301.7701-1(a)(2): When co-ownership is a partnership
- Commissioner v. Court Holding Co., 324 U.S. 331 (1945): Sale attributed to the entity that negotiated it
- Magneson v. Commissioner, 753 F.2d 1490 (9th Cir. 1985) and Bolker v. Commissioner, 760 F.2d 1039 (9th Cir. 1985): Held-for-investment after a contribution or distribution
Citations reflect U.S. federal tax law as of the article's last reviewed date.
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