The "Drop & Swap"
Last year a client reached out with a problem they were not aware how to solve. This client had purchased a property in Los Angeles along with a partner (but did not have a separate Buy/Sell Agreement), and their partner was in a position where they had to sell due to personal reasons, as was threatening to force the sale through litigation. The problem was that they held this asset in an LLC and had purchased it over 15 years prior. The property had appreciated significantly, meaning both partners were facing a substantial capital gains tax bill. For my client, the obvious solution was a 1031 exchange to defer those taxes and roll the proceeds into a new investment, but how can one person in an LLC do that without the other joining in on the exchange? — The two goals of each partner seemed incompatible on the surface, but they weren’t.
I suggested a strategy called a "drop and swap," which is designed exactly for situations like this — where co-owners in a partnership have different exit strategies and need a way to go their separate ways without one party sacrificing their tax position.
How It Works
The "drop" comes first. The partnership dissolves and transfers title out of the entity — typically an LLC — directly to the individual partners as Tenants in Common (TIC). Each partner now holds an undivided fractional interest in the property in their own name. This step is critical because 1031 exchange eligibility generally requires that the taxpayer selling the property is the same taxpayer acquiring the replacement property. Holding the asset inside a partnership entity at the time of sale can disqualify the exchange, which is why getting the title right before listing matters.
The "swap" follows at closing. Once the property sells, the partners go their separate ways. The partner cashing out pays capital gains taxes on their share of the proceeds — or, if they choose, they can roll their TIC interest into another asset independently. The partner pursuing the exchange transfers their share of the proceeds through a Qualified Intermediary (QI) into a replacement property, deferring their capital gains entirely. Each party is now operating on their own timeline, with their own objectives, without being tethered to the other.
What to Watch Out For
Timing and setup are everything. The drop needs to happen well before the property is listed or sold — ideally with enough runway to demonstrate that the TIC interest was genuinely held for investment purposes, not simply restructured right before a sale to game the tax code. The IRS scrutinizes drop and swap transactions closely, particularly the "held" requirement, which evaluates whether the taxpayer's intent was to hold the property for business or investment use rather than to engineer a quick cash-out under the guise of an exchange. The longer the TIC interest has been held before the sale, the stronger the taxpayer's position.
State-level tax considerations also deserve attention. Some states with their own capital gains taxes take the position that the "true" seller was the partnership, not the individual TIC holders, which can complicate or even undermine the structure depending on where the property is located. Legal and tax counsel familiar with both federal and state treatment is essential before moving forward.
There's also the matter of existing financing. If the property carries a loan, the partnership agreement and loan documents need to be reviewed carefully for "due on sale" clauses, which can be triggered by a change in title or ownership structure. Restructuring without lender awareness can void loan covenants or accelerate repayment obligations — an unpleasant surprise at the worst possible time.
How It Played Out
Once the legal and tax team signed off and the drop and swap was properly structured, the transaction moved forward like any other sale. I was able to sell the property at a price both partners were genuinely pleased with. The partner pursuing the exchange moved through the 1031 process and acquired a replacement property that not only generated better returns, but gave them something equally valuable — full control, without the friction of a shared decision-making structure. The other partner received their proceeds cleanly and used them for exactly what they needed.
If you own investment property with a partner and your paths are starting to diverge, a drop and swap may be the most practical way to honor both parties' goals without either side leaving money on the table. It requires the right team — an experienced real estate attorney, a knowledgeable tax advisor, and a qualified intermediary — but when it's done correctly, it's an elegant solution to what can otherwise feel like an impossible situation. If you'd like to explore whether this approach makes sense for your circumstances, feel free to reach out.