Drop and Swap 1031 Exchange: Cases, IRS Flags, Our Reading

Drop and swap, swap and drop: the two orders

Three people own an apartment building through an LLC taxed as a partnership. The building has a large built-in gain. One member wants to retire and take cash; the other two want to roll their share into new real estate and keep deferring. If the LLC sells, the LLC is the seller and the LLC decides whether there is an exchange. If the members exchange their LLC units, section 1031 does not apply at all. So practitioners change who owns the building before or after the exchange:

The names are slang. Neither the Internal Revenue Code nor the regulations use them, and none of the five court decisions on this page does either. The 2025 New York determination uses “drop and swap”, as did the state auditors' internal training document it describes.

Why the partnership cannot just split the exchange

Section 1031 works asset by asset and taxpayer by taxpayer, and a partnership interest is not real estate. The history in the U.S. Code notes corrects a date that often circulates:

• July 18, 1984. Pub. L. 98-369, section 77, rewrote section 1031(a) and added paragraph (2), whose item (D) excluded “interests in a partnership.” The effective-date note says the amendment “shall apply to transfers made after the date of the enactment of this Act [July 18, 1984]”, with a binding-contract exception for partnership interests under contracts in effect on March 1, 1984.
• 1989. Pub. L. 101-239 is the law many summaries cite for the partnership exclusion. The Code notes say something else: “Pub. L. 101–239 added subsecs. (f) to (h)”, which are the related-party rule and the foreign-property rule (our reading of the notes).
• 1990. Pub. L. 101-508 added the sentence on partnerships that elect out of subchapter K, effective back to transfers after July 18, 1984.
• 2017. Pub. L. 115-97 cut paragraph (2) to one sentence: “This subsection shall not apply to any exchange of real property held primarily for sale.” The election-out rule moved to section 1031(e), which treats such an interest “as an interest in each of the assets of such partnership and not as an interest in a partnership.”

After 2017 the exclusion of partnership units comes from the regulations. Treas. Reg. 1.1031(a)-3 lists, among things that are not real property for section 1031, “Interests in a partnership (other than an interest in a partnership that has in effect a valid election under section 761(a) to be excluded from the application of all of subchapter K)”. Treas. Reg. 1.1031(a)-1 still says section 1031(a)(1) does not apply to partnership interests whether general or limited.

The election-out door is narrow. Treas. Reg. 1.761-2 requires that the organization “must be availed of for investment purposes only and not for the active conduct of a business”, that the participants own the property as co-owners and reserve the right to take or dispose of their shares, and that any delegation of authority to sell last no more than a year. An LLC that has been filing partnership returns and running an apartment building is not, on the face of that text, the arrangement the regulation describes (our reading).

Five decisions that set the terms

Every argument about a drop and swap is built from the same five decisions. We read each opinion; the table gives what was actually decided, not what is usually said about it.

Read closely, the two Ninth Circuit cases are narrower than their reputation. In Magneson the court rested its result on the partners' continued control: “a change in the mechanism of ownership which does not significantly affect the amount of control or the nature of the underlying investment does not preclude nonrecognition under section 1031(a).” It distinguished a transfer to a corporation and an exchange for a limited partnership interest. In Bolker the court held that “the intent to exchange property for like-kind property satisfies the holding requirement, because it is not an intent to liquidate the investment or to use it for personal pursuits.” But it also recorded that “The Commissioner does not appeal the decision that Bolker individually made the exchange”, and it declined to hear the step-transaction argument because the Commissioner raised it for the first time on appeal. The question that sank Chase, who really sold, was not before the Ninth Circuit in Bolker (our reading).

The IRS position in those cases came from two revenue rulings that the court opinions describe. Under Rev. Rul. 77-337, a shareholder who liquidated his corporation under a prearranged plan to exchange its shopping center was treated as never holding it: in Bolker's words, “A never held the shopping center, and therefore section 1031(a) did not apply.” Under Rev. Rul. 75-292, an exchange followed by a transfer to a controlled corporation failed. The Ninth Circuit said revenue rulings are not binding on it. We did not find the 1975 and 1977 Cumulative Bulletins on irs.gov, so we cite both rulings as the courts described them.

The Supreme Court's sentence that every examiner quotes is from Court Holding: “A sale by one person cannot be transformed for tax purposes into a sale by another by using the latter as a conduit through which to pass title.” The Tax Court applied it in Chase and concluded that “applying the substance over form doctrine, the John Muir Investors, a partnership, rather than petitioners disposed of the John Muir Apartments.” Two facts in Chase do most of the work: the partnership agreement said “no limited partner could demand and receive property other than cash from the partnership”, and the partners received their share of the price as limited partners, not as owners.

The 2025 test case: Matter of Hadar in New York

The most recent decision on a drop and swap is a state one. New York starts from federal adjusted gross income, so its auditors applied federal law, and the record is unusually detailed. The facts, from the determination (DTA Nos. 850122 and 850123):

• An LLC owned an apartment building on Central Park West in New York City, held since 1982 by the LLC's predecessor. Its three members held 33.333%, 33.334% and 33.333%.
• Two members wanted to exchange; the third did not. On July 17, 2015 the LLC signed the contract to sell for $65,000,000.
• By a deed made as of February 1, 2016, the LLC transferred the building to three disregarded entities, one per member, as tenants in common. The building was sold to the buyer for $65,000,000 the same day. The title company recorded both deeds on February 9, 2016.
• The two exchanging members' proceeds went to qualified intermediaries; $5,000,000 was wired to one member directly and reported as taxable.
• On January 27, 2022 the state issued notices asserting $1,639,892 and $2,331,836 of additional tax, $3,971,728 together (our sum), plus penalties.

The auditor testified that the tenants in common needed to hold the building for a “[m]inimum of a couple of months.” The administrative law judge rejected that test: “the plain language of IRC (26 USC) § 1031 does not require ownership of the relinquished property for any particular period of time.” The judge relied on Magneson and Bolker, distinguished Chase because here the deeds were real and the tenants in common signed the sale documents, and noted that the auditors' “IRC § 1031 and ‘Drop & Swap’” training document was internal, not published guidance. The petitions were granted and the notices cancelled.

Three limits on what Hadar proves (our reading). It is a determination by an administrative law judge in New York, not a federal court, and it does not bind the IRS. The sale contract was signed by the LLC 199 days before the drop (our arithmetic), the very fact pattern Court Holding describes, and the taxpayers still won on this record; another forum could weigh it differently. And we checked the Division of Tax Appeals site for a Tax Appeals Tribunal decision under the same numbers on October 10, 2026 and found none posted; that does not establish whether an exception was filed.

What the IRS looks at: two questions on Form 1065

There is no IRS guide to examining drop and swaps. The IRS page that lists its Audit Techniques Guides, last reviewed on September 30, 2026, carries 21 guides; none covers like-kind exchanges (our count of the list). What the IRS does have is two questions every partnership answers on Schedule B of Form 1065:

• Question 11 is a checkbox for a partnership that, during the current or prior tax year, “distributed any property received in a like-kind exchange or contributed such property to another entity.” The 2025 instructions add that “the partnership is considered to have distributed replacement property if the partnership contributed such property to any entity other than a DE.” That is a swap and drop, or a swap followed by a contribution.
• Question 12 asks: “At any time during the tax year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property?” The instructions give the example of a partnership that “converts its title to the land to fractional interests in the name of the partners and distributes such interests to its partners” and say it must answer yes. That is a drop.

A yes on either question is not a finding that anything was wrong, and the instructions do not say what the IRS does with the answer. But a partnership that drops and swaps tells the IRS so on its return for the year of the drop (our reading).

Tenants in common after the drop: Rev. Proc. 2002-22

A drop leaves the former partners as co-owners. If they behave like a partnership, the IRS can treat the tenancy in common as one, and an interest in it would again be a partnership interest that cannot be exchanged. Rev. Proc. 2002-22 sets the conditions under which the IRS will consider a ruling that a co-ownership of rental real property is not a business entity. It is a ruling procedure, not a safe harbor, but it is the only IRS text that lists what a non-partnership co-ownership looks like:

When partners want different things: DSTs and the 721 route

A drop and swap is usually the answer to a disagreement, so it helps to see the other ways each member can get what he wants.

The member who wants to keep investing but stop managing. After the drop, that member's replacement property can be an interest in a Delaware statutory trust. Rev. Rul. 2004-86 holds that “A taxpayer may exchange real property for an interest in the Delaware statutory trust described above without recognition of gain or loss under § 1031, if the other requirements of § 1031 are satisfied.” The DST is the replacement property, so the drop question is unchanged: the member must still be the one who sold. What DSTs cost is in our analysis of DST Form D filings.

The member who wants a diversified portfolio. Section 721(a) says “No gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.” That is the route an UPREIT uses, and it is the Magneson pattern if done after an exchange. Two cautions from the text: section 721(b) withdraws the rule for a partnership that “would be treated as an investment company (within the meaning of section 351) if the partnership were incorporated”, and once a member holds operating partnership units, those units are a partnership interest, so a later 1031 exchange is closed. Our 721 exchange guide shows what fourteen REITs with DST programs reported about their repurchase plans.

The member who wants cash. The cleanest separation is often to buy that member out well before any sale, so the partnership that later exchanges has only the members who want to exchange. If one person ends up buying every other interest, Rev. Rul. 99-6 treats the partnership as making a liquidating distribution of its assets to the members and the buyer as purchasing the seller's share of the assets. Two rulings sometimes cited for drop and swaps, Rev. Rul. 99-5 and Rev. Rul. 2004-59, address different questions: a single-member LLC that becomes a partnership, and a partnership that converts to a corporation under a state formless-conversion statute.

Decision table: which route fits which split (our reading)

The table is our reading of the authorities above, not a ranking any court or the IRS has published. Practitioners disagree on how much time between the drop and the sale is enough, on whether a same-day drop can ever be respected, and on how far Hadar travels outside New York. This is an area where taxpayers have been audited and have litigated in both directions.

A worked example with our own numbers

The figures below are hypothetical and the arithmetic is ours. They apply the boot rules in section 1031(b) and (d): gain is recognized “in an amount not in excess of the sum of such money and the fair market value of such other property”, and a liability taken over by the other side “shall be considered as money received by the taxpayer on the exchange.” For simplicity, each member's share of basis equals his share of the LLC's basis, and liabilities are netted the way Treas. Reg. 1.1031(d)-2 allows.

An LLC with three equal members sells its building for $9,000,000. Its adjusted basis is $3,000,000 and it owes $3,000,000 on a mortgage paid off at closing. Each member's third: $3,000,000 of price, $1,000,000 of basis, $1,000,000 of mortgage, $2,000,000 of gain.

Across the three members, $2,600,000 of the $6,000,000 gain is taxed in the year of sale and $3,400,000 is deferred (our arithmetic). Member B's $600,000 is the cost of buying a cheaper building with less debt, not of the drop.

Now suppose an examiner wins the Chase argument and treats the LLC as the seller. There is no exchange at all: each member reports his $2,000,000 of gain, $6,000,000 in total, $3,400,000 more than in the respected case (our arithmetic). Members A and B have already spent their proceeds on new buildings and owe tax on money they no longer hold; in Hadar, the state added substantial-understatement penalties to the tax it asserted. That asymmetry, a modest saving if the drop holds and the whole gain plus penalties if it does not, is why the timing and the paperwork of the drop matter more than the exchange itself (our reading).

For comparison, a swap and drop in which the LLC exchanges the whole building and pays Member C $3,000,000 of cash out of the exchange would leave the LLC with $3,000,000 of boot, recognized up to its $6,000,000 gain under section 1031(b) (our arithmetic). How that gain is shared among members depends on the operating agreement and the partnership allocation rules, which this page does not cover.

What a co-owner can do with this

• Find the partnership's own paper first. Read the operating agreement for a clause like the one in Chase that allows only cash distributions, and for buy-sell and management terms that would follow members into a tenancy in common.
• Put time and behavior between the drop and the sale. The decisions turn on who negotiated, who signed, who paid costs and who received the money. A recorded deed, a co-ownership agreement that tracks Rev. Proc. 2002-22, separate shares of rent and expenses and separate closing statements are the opposite of the Chase record (our reading).
• Expect the question on the return. If the partnership distributes undivided interests, question 12 on Form 1065 is answered yes for that year. Plan the explanation before filing, not after a notice.
• Check the state. Hadar was a state audit of a federal question, and states can take their own positions on the same facts. A state that follows federal law can still read the same facts differently, as New York's auditors did: their notices of January 27, 2022 stood for 1,232 days before the judge cancelled them (our arithmetic).
• Run the exchange rules as usual. The drop does not change the 45-day and 180-day limits or the identification rules in our 1031 exchange rules guide; each exchanging member needs his own qualified intermediary agreement, and a member who must buy before the sale is in reverse exchange territory.

FAQ

Sources, read and saved on October 10, 2026: 26 U.S.C. 1031 and 721 with their amendment and effective-date notes, United States Code 2024 edition, Government Publishing Office (govinfo.gov); 26 CFR 1.1031(a)-1, 1.1031(a)-3 and 1.761-2 on the eCFR (text as of October 1, 2026); Rev. Proc. 2002-22 (IRB 2002-14), Rev. Rul. 2004-86 (IRB 2004-33), Rev. Rul. 99-5 and 99-6 (IRB 1999-6) and Rev. Rul. 2004-59 (IRB 2004-24) from irs.gov; IRS Form 1065 (2025) and its 2025 instructions; the IRS Audit Techniques Guides page (last reviewed September 30, 2026); Commissioner v. Court Holding Co., 324 U.S. 331 (1945), from the United States Reports at the Library of Congress; Magneson v. Commissioner, 753 F.2d 1490 (9th Cir. 1985), Bolker v. Commissioner, 760 F.2d 1039 (9th Cir. 1985), Chase v. Commissioner, 92 T.C. 874 (1989) and Maloney v. Commissioner, 93 T.C. 89 (1989), opinion texts from CourtListener; and the New York State Division of Tax Appeals determination in Matter of Hadar, DTA Nos. 850122 and 850123 (June 12, 2025). Rev. Rul. 75-292 and 77-337 are described as the court opinions describe them. Day counts, sums and the worked example are our arithmetic. This is analysis of public documents, not investment, legal or tax advice.