1031 Exchange for LLCs and Partnerships
If your investment property sits inside a multi-member LLC or partnership, a 1031 exchange is not as simple as calling a qualified intermediary and signing an exchange agreement. The law bars exchanging partnership interests directly. Here is how the options — drop-and-swap, entity-level exchange, and DST — actually work, what each costs, and where each carries IRS risk.
The Core Rule: Why Partnership Interests Don't Qualify
IRC § 1031(a)(2)(D) expressly states that the like-kind exchange rules do not apply to "any exchange of interests in a partnership." This exclusion was part of the statute before the Tax Cuts and Jobs Act of 2017 (TCJA) and remains fully in force today.1
What this means in practice: a limited partner or LLC member who wants to exit cannot simply swap their partnership interest for a replacement partnership interest and defer the gain. The interest itself is not eligible property, regardless of what the underlying partnership owns.
The exclusion creates a structural problem for the most common form of investment real estate ownership. An enormous share of commercial, multifamily, and rental properties in the U.S. is held inside multi-member LLCs or limited partnerships, often with two, three, or a dozen co-investors. When the group decides to sell, the entity structure blocks the most straightforward exchange path — but it does not eliminate deferral altogether.
What It Does Not Prevent
The §1031(a)(2)(D) exclusion applies to exchanges of partnership interests — not to exchanges conducted by a partnership. A partnership or LLC that directly owns real property can do a 1031 exchange at the entity level. The entity sells the relinquished property and acquires replacement property, deferring gain inside the partnership. All partners' deferred gain is preserved on a proportional basis through carryover basis mechanics. The limitation is that individual partners cannot go separate directions — everyone defers (or everyone doesn't) based on what the entity does.
Single-Member LLCs: The Clean Case
A single-member LLC (SMLLC) is a disregarded entity for federal income tax purposes under Treasury Regulation § 301.7701-3.2 The IRS treats the LLC as if it does not exist separately from its sole owner. The member directly owns the real property for tax purposes, even though the deed is in the LLC's name.
As a result, a SMLLC doing a 1031 exchange works exactly like an individual doing a 1031 exchange:
- The qualified intermediary agreement is with the LLC, which is effectively the member.
- The exchange is reported on the member's personal return (Schedule E and Form 8824).
- The §1031(a)(2)(D) problem does not arise because there is no partnership.
- The member can direct exchange proceeds into any eligible replacement property without the other-partner coordination issues that affect multi-member structures.
If a single-member LLC converts to a multi-member LLC (by admitting a new member), the disregarded-entity status is lost and the entity is treated as a partnership from that point forward — reintroducing the structural problem. The conversion triggers no immediate tax, but the exchange flexibility disappears.
Multi-Member LLCs and Partnerships: Three Paths
When two or more unrelated investors hold property through a multi-member LLC or partnership, they have three realistic options when a sale is imminent:
1. Entity-level exchange
The entity exchanges the relinquished property for replacement property. All partners defer gain proportionally. No drop required. But all partners must agree on the replacement property — and anyone who wants cash instead of deferral creates a complication.
2. Drop-and-swap
The LLC distributes undivided tenancy-in-common (TIC) interests to each member before the sale. Each member then separately exchanges their TIC interest. Requires enough advance time to satisfy investment-intent tests.
3. Delaware Statutory Trust
The group sells the relinquished property (entity takes the taxable gain or does an entity-level exchange), and members who want to defer reinvest individually into a DST as replacement property. Clean break from the entity structure — but DST restrictions apply.
Drop-and-Swap: How It Works and Where It Gets Risky
Drop-and-swap is the most common structure used when partners want to do independent 1031 exchanges after a joint sale. The mechanics are straightforward in concept but legally sensitive in execution.
Step-by-Step Mechanics
- Drop: The LLC or partnership distributes undivided tenancy-in-common interests to each member in proportion to their ownership percentages. The distribution is treated as a liquidating or partial distribution under IRC § 731, which generally does not trigger gain recognition at the partner level (subject to the exceptions below).
- Hold: Each member now holds a TIC interest in the real property directly — not a partnership interest. They are co-owners of an undivided fraction of the underlying real estate.
- Sell and exchange: The co-owners sell the property (or each member independently enters a 1031 exchange for their TIC interest). Each member contracts with their own qualified intermediary, identifies replacement property independently, and completes separate exchanges on independent timelines.
Why It Works Technically
After the drop, each member owns real property directly — an undivided fractional interest, not a partnership interest. This is eligible property under § 1031. Revenue Procedure 2002-22 provides a safe harbor confirming that undivided fractional interests in real property (up to 35 co-owners) can qualify as like-kind property for 1031 exchange purposes, provided the TIC arrangement does not cross into partnership territory through joint management, profit sharing, or governance structures that look like a partnership.3
The Investment-Intent Timing Risk
Here is where drop-and-swap gets complicated: § 1031 requires that the exchanged property was "held for productive use in a trade or business or for investment." The IRS and tax courts apply a facts-and-circumstances test to determine whether a TIC interest distributed shortly before a sale was genuinely held for investment — or was created solely to facilitate an exchange.
If the distribution occurred too close to the sale, the IRS can argue that the TIC interest was not held for investment; it was acquired to be immediately disposed of in an exchange. Under this logic, the exchange fails and the gain is recognized immediately.
§ 731 Distribution Traps
The drop itself is not automatically tax-free. A few situations trigger immediate gain recognition even in a drop-and-swap:
- Disproportionate distributions: If some members receive cash and others receive TIC interests, the cash distributions may trigger gain under § 731(a) to the extent they exceed the receiving partner's outside basis.
- Hot assets (§ 751): If the partnership holds unrealized receivables or substantially appreciated inventory, a distribution may trigger ordinary income even when the distributed property itself is real estate.
- Low outside basis: A partner with a low outside basis in their partnership interest may recognize gain if the distribution includes relief from partnership liabilities — especially relevant if the entity carries a mortgage.
Before executing a drop-and-swap, each partner should run their own basis and liability analysis with a CPA. The entity-level exchange or DST route may be cleaner for partners with complex basis situations.
Rev. Proc. 2002-22 TIC Requirements
For the distributed TIC interest to qualify as replacement property in another investor's exchange (or as the relinquished property in the member's own exchange), it must conform to the tenancy-in-common requirements of Revenue Procedure 2002-22. Key requirements:3
| Requirement | Detail |
|---|---|
| Maximum co-owners | 35 — including co-owners who are themselves entities (each entity counts as one) |
| Undivided interest | Each co-owner must hold an undivided fractional interest in the whole property — not a divided or allocated portion |
| No new TIC formation | Each co-owner must be able to transfer, partition, or encumber their interest without the other co-owners' consent (within any reasonable restrictions) |
| No partnership treatment | The co-ownership arrangement must not be treated as a partnership under state law or operate like a partnership in substance (e.g., no profit-sharing beyond pro-rata ownership) |
| Unanimous approval for major decisions | Leasing, management agreements, and capital expenditures above a de minimis threshold require unanimous co-owner consent |
| No business activities | The TIC arrangement must be passive — co-owners cannot operate a business through the property in a way that would make it a joint venture |
Entity-Level Exchange ("Swap"): When All Partners Agree
When partners agree to stay together through the exchange — deferring as a group into a shared replacement property — the entity-level exchange is the cleanest and lowest-risk structure. No partnership interests are being exchanged; the entity is exchanging real property for real property, which is fully eligible.
The entity executes the exchange through a qualified intermediary in the normal way: exchange agreement, relinquished property sale, identification of replacement property within 45 days, acquisition within 180 days. The partnership continues with carryover basis in the replacement property, and each partner's share of deferred gain is preserved proportionally inside their partnership interest basis (outside basis adjusted per § 705).
The Disagreement Problem
The entity-level exchange breaks down when partners disagree. Common scenarios:
- One partner wants cash to pay estate taxes or fund retirement. The others want to defer.
- The group cannot agree on a replacement property before the 45-day identification deadline.
- One partner has a very low basis and a large deferred gain — taking boot is unacceptable, but the group is settling for a weaker replacement property than that partner wants.
In these cases, the entity-level exchange fails as a solution. Drop-and-swap or DST becomes the alternative.
Swap-and-Drop: Caution Required
A related structure — swap-and-drop — has the entity complete the exchange first (acquiring the replacement property as a group), then distributes interests in the replacement property to individual members afterward. This avoids the pre-sale timing risk of drop-and-swap, but it creates a different problem: after the distribution, the IRS may scrutinize whether the partners who received replacement property interests "held" them for investment or immediately disposed of them. Courts have been skeptical of swap-and-drop arrangements where the distribution into smaller entities or individual ownership followed shortly after the exchange. The 2-year holding period commonly cited for drop-and-swap applies here too, but in the opposite direction — hold the replacement property long enough that the distribution does not look like a pre-planned disassembly.
DST as a Clean Entity Exit
For partners who want to exit the group structure and defer independently, Delaware Statutory Trusts offer a structurally cleaner solution than either form of the drop/swap mechanics:
- The entity sells the relinquished property. If the entity wants to defer at the entity level first, it can exchange into a DST as replacement property — but more commonly, partners who want individual deferral take cash from the entity-level taxable sale and reinvest that cash into DST interests directly through their own 1031 exchanges.
- Each partner signs their own DST subscription and exchange agreement. They are now individual beneficial interest holders in the DST — not partnership interest holders.
- The DST is eligible like-kind property under Revenue Ruling 2004-86, confirmed by the IRS to qualify as replacement property in a 1031 exchange.4
The tradeoff is that DST investors accept the Seven Deadly Sins restrictions: no new debt, no capital calls, no lease renegotiation outside normal course, no property improvements beyond ordinary maintenance, and no new investors after the trust closes. The DST sponsor manages the property; investors have no operating control. See the DST guide and UPREIT vs DST guide for the full analysis.
For partners who want to exit the management burden of direct real estate anyway — particularly those approaching retirement or with liquidity needs — the DST route sidesteps the drop-and-swap timing risk entirely while preserving deferral at the individual level.
Worked Example: 3-Member LLC Selling a $4.5M Apartment Building
Three equal partners — A, B, and C — hold a 12-unit apartment building in a multi-member LLC. The building's adjusted basis is $900,000 after accumulated depreciation of $400,000 over 14 years. Sale price: $4.5M. Each partner holds a one-third interest.
| Entity total | Per partner (1/3) | |
|---|---|---|
| Sale price | $4,500,000 | $1,500,000 |
| Adjusted basis (after depreciation) | $900,000 | $300,000 |
| Total gain | $3,600,000 | $1,200,000 |
| §1250 unrecaptured depreciation (25%) | $400,000 | $133,333 |
| Long-term capital gain (20%) | $3,200,000 | $1,066,667 |
| NIIT (3.8% on LTCG + recapture, if applicable) | ~$136,800 | ~$45,600 |
| Approximate federal tax if sold taxably | ~$776,800 | ~$258,933 |
Each partner can defer approximately $259,000 in federal tax through a 1031 exchange. The three partners have different situations:
- Partner A wants to retire and needs income. Prefers DST interests that produce monthly distributions without management obligations.
- Partner B wants to exchange into a larger multifamily as sole owner. Wants to control the replacement property selection independently.
- Partner C wants cash — has an estate planning need and prefers to pay tax now, harvest the step-up at death on other assets, and exit real estate entirely.
Option 1: Entity-Level Exchange
Doesn't work here — Partner C wants cash and Partner A wants DST, not a co-owned multifamily. One dissenting partner blocks a clean entity exchange.
Option 2: Drop-and-Swap (if timing allows)
If the partners planned far enough ahead (18–24 months before the sale), the LLC could have distributed TIC interests to each member. Partner A exchanges her TIC interest for DST interests. Partner B exchanges his TIC interest for a replacement multifamily. Partner C takes her TIC interest proceeds as a taxable sale — she gets cash at the cost of her $259K federal tax hit. Each transaction is fully independent.
If the decision to sell came suddenly (within the last 12 months), the drop-and-swap carries IRS scrutiny risk on the investment-intent question. Proceeding requires a CPA's documented opinion that the TIC interest was genuinely held for investment — not just a step to facilitate the exchange.
Option 3: DST for Those Who Want to Defer, Cash for Partner C
The entity sells the building as a taxable sale. Partner C gets her $500,000 cash (less ~$259K federal tax). Partners A and B each receive $500,000 in sale proceeds, which they reinvest individually into DST interests within 180 days. Each signs their own exchange agreement, identifies DST interests within 45 days, and reports their exchange on their personal returns via Form 8824. The taxable sale at the entity level eliminates the need for drop-and-swap timing but requires Partners A and B to reinvest the cash into DSTs rather than direct real estate (unless they each identified their own replacement properties within 45 days, which is possible but logistically complex). This approach is cleaner from an IRS perspective and is commonly used when the group is misaligned on exit strategy.
Comparison: Which Structure Fits Which Situation
| Situation | Best structure | Key risk |
|---|---|---|
| All partners want to defer into shared replacement property | Entity-level exchange | All must agree on replacement property by 45-day deadline |
| Partners want to go different directions; 18+ months of planning time | Drop-and-swap | Investment-intent scrutiny; §731 distribution traps |
| Partners want to go different directions; sale is imminent (<12 months) | Entity sale, then individual DST exchanges | DST restrictions (Seven Deadly Sins); no direct property control |
| One partner wants cash; others want to defer | Entity taxable sale + individual DST exchange for deferring partners | Deferring partners must reinvest cash within 180 days |
| Single-member LLC | Standard 1031 exchange (disregarded entity) | None specific to entity structure |
| Partners want DST→UPREIT path long-term | Entity-level DST exchange, then §721 conversion | 2-year safe harbor; state clawback risk at conversion |
What a Financial Advisor Models Across the Group
The LLC/partnership structure turns a 1031 exchange decision from an individual calculation into a multi-party negotiation. A fee-only financial advisor working with a multi-member group can provide analysis that CPAs and qualified intermediaries typically do not:
- Per-partner tax and net-proceeds modeling. Each partner has a different outside basis, a different share of accumulated depreciation, and different non-real-estate income that affects their NIIT exposure, applicable LTCG rate, and state tax situation. The tax cost of deferring versus paying tax now varies significantly across partners.
- DST due diligence and sizing. For partners who want to exit into DSTs, the advisor evaluates DST sponsor quality, property-level fundamentals, distribution coverage ratios, and the total equity required to fully defer each partner's individual gain — including how the debt-replacement requirement affects DST sizing if the old entity carried a mortgage.
- Estate and step-up modeling. For older partners who are considering accepting taxable proceeds (like Partner C above), the advisor models the value of the step-up at death under IRC § 1014 against the cost of paying tax now versus deferring into a property that may have its own appreciation and depreciation chain.
- Timing coordination. The 45-day and 180-day deadlines apply individually to each partner doing their own exchange. The advisor coordinates timing with the QI so that each partner's exchange agreement is signed, their proceeds are held properly, and their identification letters go out on time — even when three people are going three separate directions on the same transaction date.
See the financial advisor for 1031 exchange guide for the full advisory team structure and the eight questions to ask before engaging anyone.
Sources
- IRC § 1031(a)(2)(D) — Exclusion of partnership interests from like-kind exchange treatment. law.cornell.edu/uscode/text/26/1031
- Treasury Regulation § 301.7701-3 — Classification of entities; single-member LLC as disregarded entity for federal income tax purposes. law.cornell.edu/cfr/text/26/301.7701-3
- Revenue Procedure 2002-22 — Safe harbor conditions for undivided fractional interest (TIC) arrangements in real property to qualify as like-kind replacement property under § 1031. irs.gov/pub/irs-drop/rp-02-22.pdf
- Revenue Ruling 2004-86 — IRS confirmation that beneficial interests in a Delaware Statutory Trust qualify as like-kind real property for § 1031 exchange purposes. irs.gov/pub/irs-drop/rr-04-86.pdf
- IRC § 731 — Extent of recognition of gain or loss on distribution from partnership. law.cornell.edu/uscode/text/26/731
Tax rates used in the worked example reflect 2026 federal rules: §1250 unrecaptured depreciation at 25%, long-term capital gains at 20%, NIIT at 3.8%. State taxes not included in worked example totals. Revenue Procedure 2002-22 TIC requirements and Revenue Ruling 2004-86 DST qualification reflect IRS guidance as of June 2026 — Congress has not modified these rules in TCJA, SECURE 2.0, or OBBBA. Consult a qualified CPA, tax attorney, and financial advisor before executing any multi-entity exchange structure.
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Multi-partner exchanges require per-partner modeling, timing coordination across multiple QI agreements, and sometimes the negotiation that keeps a group from missing deadlines because one partner wants a different outcome. Tell us about your situation and we will match you with a fee-only advisor who works with LLC and partnership-held real estate.