Drop-and-swap 1031 exchanges
for California partnerships.
When the partnership is splitting and each partner needs their own redeployment, the standard 1031 doesn’t work. The drop-and-swap is the structure that does. ARCA is one of the few California 1031 exchange brokers that has executed these end to end.
A drop-and-swap (sometimes written drop and swap) is a 1031 exchange structure used when a partnership owns the relinquished property but the partners want to redeploy their equity into different replacement assets. Before the sale, the partnership distributes the property to its members as tenants-in-common, typically supported by a Section 761 election that takes the partnership out of subchapter K for that asset. Each former partner then executes their own 1031 exchange on their TIC interest, into the replacement property of their choice. The result: one disposition, multiple individual redeployments, no shared ownership on the back end.
Most California real estate partnerships with diverging objectives are candidates for this structure. It’s also the only clean answer when one partner wants to retire into stabilized passive income while another wants to keep building a value-add platform. The drop-and-swap (sometimes called a partnership 1031 exchange) is the only mechanism that lets each partner walk out of the same disposition into a redeployment that actually fits their own life.
We’ve executed enough of these to know where the structure breaks. The page below is what we’d walk through in a first meeting: the mechanics, the timing constraints that decide whether the structure holds up under IRS review, the team you’ll need around the trade, and the way ARCA, your CPA, your attorney, and the qualified intermediary actually divide the work.
How a drop-and-swap actually works.
Three steps, three different professionals, one synchronized timeline. None of them works if the others are running on a different schedule.
The drop.
Before the property is sold, the partnership distributes its real estate to the partners as tenants-in-common. Each former partner now holds an undivided fractional interest in the property in their individual capacity rather than through the partnership. The drop is documented through the partnership’s operating agreement, an amendment or dissolution document, and updated title records reflecting the TIC ownership.
The TIC interests can be held by each partner directly or, more commonly, through individual single-member LLCs. A single-member LLC that hasn’t elected corporate tax treatment is treated as a “disregarded entity” for federal tax purposes, which means the LLC and its individual member are the same taxpayer for §1031, so the same-taxpayer rule is preserved through the exchange. Most sophisticated owners take title in their LLC for liability protection, cleaner estate planning, and lender preference on the replacement-side financing. Each partner needs their own separate SMLLC; a multi-member LLC would re-create the partnership problem this whole structure exists to solve.
The Section 761 election.
For the drop to support a clean §1031 exchange on the back end, the partnership generally needs to file a Section 761(a) election. The election removes the partnership from subchapter K of the Internal Revenue Code with respect to that asset, treating it for federal tax purposes as co-owned investment property rather than partnership property. This is the structural step that lets each partner’s individual 1031 stand on its own.
Without the election, or a similar structural mechanism, the IRS can argue the relinquished property is still partnership-held and disqualify the individual exchanges. Your CPA structures and files this election. ARCA does not.
The swap.
With each partner now holding TIC investment property in their own name, each runs their own 1031 exchange under standard federal rules: 45 days to identify replacement candidates in writing, 180 days to close, a qualified intermediary holding the proceeds during the window so no partner has constructive receipt. Each partner can identify and close on different replacement properties, in different markets, with different operating profiles. The 1031 exchange partnership split that started as one disposition resolves into multiple individual redeployments.
Why timing is where most drop-and-swaps fail.
The IRS doesn’t grade the drop-and-swap on whether the paperwork is correct. It grades on whether the structure was real or just a same-day workaround. Timing is how you prove it was real.
There is no published bright-line rule on how far in advance of the sale the drop step in a drop and swap needs to occur. Practitioners use phrases like “long enough that the partners genuinely held investment property in their individual capacity,” which is a defensible standard but not a comfortable one. Court decisions have validated drop steps that occurred years before the eventual sale; the IRS has challenged structures where the drop occurred the same week as closing.
The conservative path. Drop well before the listing agreement is signed, ideally well before the partners have decided to sell. This way, there is a clean documentary record that each partner held TIC investment property in their individual capacity, paid taxes on it in that capacity, and made operational decisions about it, all before the sale was on the horizon. The further the drop is from the sale, the cleaner the structure looks under audit.
The riskier path. Drop after the property is already under contract, on the theory that the partnership is winding down anyway. Some structures get done this way. They are also the structures most likely to be challenged on audit, and the structures where the §761 election needs to do the heaviest lifting. We can still execute, but the structuring window is meaningfully narrower.
What ARCA flags at the pre-listing call. If the partnership is contemplating a sale and any of the partners is contemplating a 1031 into something different from what the others want, the drop step needs to be on the calendar before anything is signed on the disposition side. Once the listing is public, the structuring window is narrower. Once the property is under contract, narrower still.
The swap-and-drop variant. A swap-and-drop is the inverse: the partnership runs the 1031 first, acquires the replacement as a partnership, and only later distributes the replacement to the partners as TIC. It carries different timing risks and is sometimes the right choice when an early drop wasn’t possible at the front end. Your CPA, your attorney, and ARCA would walk through which variant fits your specific situation.
If you call us and the partnership has already signed the listing or is already under contract, we can still execute. We’ve been retained mid-stream more times than at the start. The earlier you bring us in, the more options remain on the table.
A clean drop-and-swap takes four parties, not one.
This is the engagement where the broker can’t substitute for the CPA, the CPA can’t substitute for the attorney, and none of them can substitute for the qualified intermediary. The structure works because all four roles run in formation.
- Disposition representation on the partnership-held California property: pricing, positioning, marketing, buyer sourcing, closing coordination.
- Replacement-side identification and acquisition for each partner individually, underwritten against each partner’s own economics, within their 45-day window.
- Timeline orchestration across the partners, the CPA, the attorney, the QI, escrow, title, lenders, and any 1031 facilitator.
- CA-to-49-states replacement search: California 1031 exchange to Texas, Arizona, Nevada, Florida, Tennessee, the Carolinas, and selectively into other state markets.
- CPA: structures the §761 election, opines on tax treatment, files the partnership return, files FTB Form 3840 annually for each partner under the California clawback rule.
- Partnership attorney: drafts the partnership amendment or dissolution agreement, the TIC agreement among the new co-owners, and any related instruments.
- Qualified Intermediary (QI): holds each partner’s individual sale proceeds during the 45/180-day window. Each partner uses a QI; proceeds are not commingled.
- Title and escrow: process the TIC distribution recording on the relinquished side and the deed work on each partner’s replacement-side closing.
A drop-and-swap, in practice.
Two partners, one large California asset, two individual NNN portfolios on the back end.
Two partners had owned a large single-tenant retail property in Pasadena for years. The asset itself wasn’t the issue. It had performed; the tenant was long-standing; the rent roll cleared. The structure was the issue. Both partners had reached a point in their lives where their estate plans pointed in different directions, and an undivided half-interest in one large property wasn’t the right vehicle for either of them going forward.
We sequenced the drop step well in advance of the listing. Each partner’s CPA filed the §761 election. By the time we went to market, each partner held their TIC interest in their individual capacity, with the documentary record to support it. We took the disposition into a deep pool of buyers for stabilized single-tenant retail and closed at a number that cleared the submarket’s trailing comp set.
The harder work happened on the replacement side, because both partners were running individual 1031s off the same disposition but into different individual profiles. One gravitated toward fewer, larger, more visible single-tenant holdings; the other preferred a wider spread across more tenants for broader diversification. Both outcomes were direct individual ownership of California-based sale-leaseback portfolios with long-term NNN structures and investment-grade tenants. We arranged a financing package against the 1031 debt-replacement requirement so neither partner caught boot on the math.
Both individual exchanges closed inside their 180-day windows. Both partners ended in direct individual ownership of NNN portfolios aligned to their own estate plans, with no remaining shared liabilities between them. An asset that had been complicated by its ownership structure became two simpler holdings that each partner (and going forward, each partner’s heirs) can direct independently.
Few brokers execute these. We do.
Drop-and-swap is one of the engagements where most commercial brokers either don’t take it on or hand it off. ARCA’s principals have run them, end to end, for California partnerships across asset classes.
ARCA is a Pasadena, California commercial real estate brokerage with senior principals from Marcus & Millichap and NGKF Capital Markets. Combined, the team has 107 years of California licensing and over $5.5 billion in closed transaction volume across 15 states. A meaningful share of that volume is partnership 1031 work, including drop-and-swap structures where the §761 election was load-bearing.
Matthew W. Dobson, Managing Partner and Broker of Record, leads the firm’s complex deal structuring and 1031 practice. Direct line at the bottom of this page if you’d rather skip the form. Joshua L. Levy, Managing Partner, leads the investment sales and capital markets practice and works alongside Matt on the larger partnership exits.
ARCA is licensed in California (CA DRE Corp #01980430) and Georgia, with active engagements across 15 states. We are not a Qualified Intermediary, not a CPA, and not a partnership attorney. Your funds never touch us. We broker the trade; the rest of the team does the rest of the work.
Questions partnerships tend to ask.
What is a drop-and-swap 1031 exchange?
A drop-and-swap is a 1031 exchange structure used when a partnership owns the property being sold but the individual partners want to redeploy their equity into different replacement assets. Before the sale, the partnership distributes the property to its partners as tenants-in-common. Each partner then executes their own 1031 exchange independently into a replacement property of their choice. It is sometimes called a partnership 1031 exchange.
Is a drop-and-swap legal?
Yes. Drop-and-swap structures are recognized in IRS guidance and have been validated in tax court rulings. They require careful execution, particularly around timing and the Section 761 election, but they are an accepted way for partners with diverging investment objectives to each run a 1031 exchange off the same disposition. Most challenges arise from sloppy timing, not from the structure itself.
How long before the sale does the drop step need to happen?
There is no published bright-line rule. Conservative practitioners want the drop completed well before the listing agreement is signed, ideally well before the partners have committed to selling. Drops executed shortly before close, or after the property is already under contract, are technically permitted but more vulnerable to IRS challenge. The earlier the drop, the cleaner the structure under audit. This is one where we recommend you speak to your CPA and let them guide you.
What is a Section 761 election?
A Section 761(a) election removes the partnership from subchapter K of the Internal Revenue Code with respect to a specific asset, treating it as co-owned investment property held by the individual partners rather than as partnership property. In a drop-and-swap, this election is what allows each partner’s subsequent 1031 exchange to stand on its own without being treated as a partnership transaction. The CPA structures and files the election.
Can I do a partnership 1031 without a drop-and-swap?
Yes, when all the partners want to redeploy into the same replacement asset. The partnership simply continues to hold the replacement property after the exchange. A drop-and-swap is needed when the partners want different replacement profiles: different markets, different asset classes, different hold horizons, or different ownership structures going forward.
Can each partner drop into a single-member LLC instead of holding the TIC interest personally?
Yes, and most sophisticated owners do. A single-member LLC that hasn’t elected corporate tax treatment is treated as a disregarded entity for federal tax purposes, which means the LLC and its individual member are the same taxpayer for §1031. The same-taxpayer rule is preserved, the exchange is clean, and the partner gets liability protection, cleaner estate planning, and stronger lender preference on the replacement-side financing.
Two structural rules: each partner needs their own separate single-member LLC (a multi-member LLC re-creates the partnership problem), and the LLC must not have filed Form 8832 to elect corporate tax treatment. California-specific cost note: each LLC carries an $800 annual minimum franchise tax plus a gross-receipts fee on rental income above $250,000, which is small per partner but is an ongoing carrying cost worth modeling.
What is a swap-and-drop, and how is it different?
A swap-and-drop is the inverse structure. The partnership runs the 1031 first, acquires the replacement property as a partnership, and later distributes the replacement to the partners as tenants-in-common. It has different timing risks than the standard drop-and-swap and is sometimes used when an early drop wasn’t possible. Both variants face IRS scrutiny on the holding period of the relinquished or replacement property.
Who needs to be involved in a drop-and-swap?
At minimum, four parties: a commercial real estate broker (ARCA’s role) handling disposition and replacement-side acquisition; a CPA structuring the Section 761 election and tax filings; a partnership attorney drafting the dissolution and TIC agreements; and a Qualified Intermediary holding each partner’s individual proceeds during the 45/180-day window. If any one of them is missing, the structure is exposed.
How does a drop-and-swap interact with the California clawback (FTB 3840)?
The California clawback (FTB Form 3840) tracks deferred gain originally sourced from California real property after a 1031 exchange into out-of-state replacement. In a drop-and-swap, each former partner who exchanges into out-of-state replacement property continues to file FTB Form 3840 annually until the gain is recognized or can be extinguished through step-up at death. The clawback runs at the individual taxpayer level after the drop, which is one reason individual ownership matters.
Can ARCA broker a drop-and-swap that is already in motion?
Yes. We are regularly retained on engagements where the property is already under contract, the partnership is already winding down, or the 1031 clock is already running. Coming in mid-stream is harder than at pre-listing, and the timing options are narrower, but it is workable in most situations. The earlier in the process we are involved, the more structural options remain on the table.
What are the IRS risks if a drop-and-swap is challenged?
If the IRS successfully recharacterizes the transaction, the relinquished property may be treated as having been sold by the partnership, disqualifying each partner’s individual 1031. The result is a fully taxable disposition at the partnership level, with federal capital gains, depreciation recapture, and California state tax all coming due in the year of sale. The structural defenses to a challenge are real, but they require timing discipline and contemporaneous documentation.
One hour. Confidential. No obligation.
If you’re contemplating a partnership exit, a drop-and-swap, or a Section 761-driven exchange, the first call costs nothing but the hour. Bring whatever you have: the partnership agreement, a current valuation or recent broker opinion, a sense of where each partner wants to land. Most clients spend several months thinking through the shape of an exit before going to market. That’s the right pace.
Direct line for partnership 1031 inquiries goes to Matt Dobson, ARCA’s Managing Partner and Broker of Record.
