Splitting Up a Partnership or LLC in a 1031 Exchange

We spoke recently with three siblings who had inherited an apartment building through a family LLC. For years the arrangement worked beautifully. But as lives do, theirs had drifted in different directions. Two of them wanted to keep investing in real estate and defer every dollar of tax they could. The third had a growing family and a mortgage of her own, and simply wanted to be paid out — though she was in no hurry and did not need all of the money at once.

The building was worth about $3 million, free and clear, and a buyer had begun sniffing around. The siblings assumed that when they sold, each of them could independently decide what to do with their third — two rolling into a 1031 exchange, one taking cash. It is one of the most common assumptions in this business. It is also, without careful planning, wrong.

The reason is a rule that catches almost everyone off guard: you cannot do a 1031 exchange of a partnership interest. This article is about how families and business partners address that rule when they want to go separate ways — the drop-and-swap, the swap-and-drop, and a particularly elegant variation in which an installment note is assigned to the departing partner so that each owner defers tax through an entirely different part of the code.

The Barrier: A Partnership Interest Is Not Real Property

Section 1031 applies only to real property held for productive use in a trade or business or for investment. An interest in an LLC taxed as a partnership is not real property — it is an interest in an entity. For most of the statute's history, IRC §1031(a)(2)(D) expressly excluded "interests in a partnership" from like-kind exchange treatment. After the 2017 Tax Cuts and Jobs Act limited §1031 to real property, that express exclusion became unnecessary — a partnership interest simply is not real property, so it cannot be exchanged.

This is the crux of the siblings' problem. The apartment building is real property. But what each sibling owns is a membership interest in a tax partnership — and that is precisely the thing the code will not let them exchange. If the LLC sells the building and distributes the cash, the gain flows through to all three siblings on their K-1s. The two who want to defer cannot simply roll "their share" into an exchange, because a partnership interest is not exchangeable, and the entity — not the individuals — was the seller.

So the planning question becomes: how do you separate the owners so that each can pursue their own tax objective? The answer is to change who the taxpayer is before the sale — or, in one variation, to restructure what each owner receives after it. That is the entire theory behind the split-up strategies below.

Strategy One: The Drop-and-Swap

The most widely used solution is the drop-and-swap. The name describes the two steps, in order:

The "drop": Before any sale, the LLC distributes the real property out to its members as undivided tenancy-in-common (TIC) interests, in liquidation of their membership interests. The entity "drops" the real estate down to the individuals. Each sibling now holds a direct, deeded fractional interest in the building — real property — instead of a membership interest in an entity.
The "swap": Each co-owner then does whatever they wish with their own TIC interest. The two siblings who want to defer each conduct their own 1031 exchange, through a qualified intermediary, into their own replacement property. The sibling who wants cash simply sells her TIC interest and pays her tax.

Because each person now owns real property directly, the partnership-interest barrier disappears. The taxpayer selling is the same taxpayer acquiring replacement property — satisfying the "same taxpayer" requirement that is the backbone of every valid exchange. One owner can defer, another can cash out, and a third could even do a partial exchange, all from the same building.

The legal footing for this is stronger than many advisors realize. In Bolker v. Commissioner, the Ninth Circuit — the federal appellate circuit that governs Washington — allowed a taxpayer who received property in the liquidation of his corporation to immediately exchange it under §1031, holding that the "held for productive use or investment" requirement was satisfied because he intended to continue his investment in a different form rather than to cash out. The drop, in other words, does not automatically poison the swap.

Strategy Two: The Swap-and-Drop

Sometimes the timing runs the other way. The buyer is ready, the closing is imminent, and there is simply no time to retitle the property into TIC interests before the sale. In that case, the sequence flips into a swap-and-drop:

The "swap": The partnership itself sells the relinquished property and completes a 1031 exchange at the entity level, acquiring replacement real estate in the LLC's name.
The "drop": After the exchange, the partnership distributes the replacement property (or interests in it) out to the members who want to go their separate ways.

The Ninth Circuit blessed this direction, too. In Magneson v. Commissioner, the court allowed an exchange followed by the contribution of the received property into a partnership, again on the theory that the taxpayer had continued the investment rather than liquidated it. Read together, Bolker (drop then swap) and Magneson (swap then drop) stand for the same principle: a change in the form of ownership immediately before or after an exchange does not, by itself, destroy the exchange, so long as the taxpayer is continuing an investment rather than cashing out.

The swap-and-drop has one practical drawback: the members are tied together through the exchange itself. Everyone has to agree to the replacement property, and the member who wants cash generally has to wait until after the drop to sell — which can create its own boot and timing issues. For that reason, the drop-and-swap, done early, is usually the cleaner path when there is time to plan.

The Warning Case: Chase, and Why Timing and Conduct Matter

None of this is a free pass. The most important cautionary tale is Chase v. Commissioner, in which the Tax Court denied §1031 treatment. There, the court found that the partnership — not the distributee partners — was the true seller. The partners had received their interests on paper immediately before closing but never actually behaved like owners: they did not individually negotiate the sale, collect rents, or exercise the rights of ownership. Substance won over form, the partnership was treated as the seller, and the attempted exchanges failed.

The IRS has two doctrines it deploys against a sloppy drop-and-swap:

The step-transaction doctrine, which collapses the "drop" and the "sale" into a single step — treating the whole thing as a sale of a partnership interest, or a sale by the partnership followed by a distribution of cash. Either way, the individual exchange evaporates.
The "held for investment" requirement of §1031(a). The Service has long argued, in rulings such as Rev. Rul. 75-292 and Rev. Rul. 77-337, that property acquired immediately before an exchange and solely for the purpose of exchanging it was not "held for" investment. There is no statutory minimum holding period — but the shorter the interval between the drop and the sale, the more the transaction looks like a prearranged plan.

These doctrines did not appear out of nowhere. Their foundation is a 1945 Supreme Court decision, Commissioner v. Court Holding Co., which is the single most important case to understand before a partnership even thinks about dropping property that is already under contract. In Court Holding, a corporation negotiated the sale of an apartment building and then — to avoid a corporate-level tax — tried to liquidate and let its shareholders sign the final sale. The Supreme Court refused to respect the maneuver, holding that “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.” Because the corporation had already negotiated and effectively arranged the sale, it remained the true seller no matter whose name went on the closing documents. The lesson for a partnership is blunt: if the partnership has already signed — or substantially negotiated — a purchase and sale agreement before it drops the property to its members, Court Holding lets the IRS treat the partnership as the seller anyway, collapsing the drop and taxing the gain at the entity level before any member ever gets to attempt an individual exchange. The companion case, United States v. Cumberland Public Service Co., shows the other side of the line: there the shareholders — not the corporation — genuinely conducted the sale, and the distribution was respected. The dividing line is always the same question — who actually negotiated and carried out the sale?

The encouraging counterpoint is PLR 202416012 (2024), in which the IRS respected a drop-and-swap where the distribution was mandated by the governing instrument and was genuinely independent of the exchange. The lesson across all of this authority is consistent: the drop must be real, it must be early, and the new owners must actually act like owners.

Doing the Drop-and-Swap Right: The Rev. Proc. 2002-22 Guardrails

The single most effective way to defend a drop-and-swap is to make sure that, once the property is dropped, the co-owners hold it as a genuine tenancy in common and not as a "disguised partnership" that the IRS can simply re-aggregate. The roadmap for this is Revenue Procedure 2002-22, the IRS's guidelines for when a TIC arrangement will be respected as co-ownership of real estate rather than an entity. In practice, that means:

Drop early — ideally in a prior tax year. The more time between the drop and the sale, the weaker any step-transaction argument becomes. A distribution done in the same week as closing is an audit magnet; one done a year earlier looks like ordinary estate and investment planning.
Each co-owner must act like an owner. Hold title individually, share rents and expenses pro rata, receive separate K-1s or report directly, and — critically — negotiate and sign the sale individually, as the taxpayers in Chase failed to do.
Require unanimity for major decisions. Rev. Proc. 2002-22 contemplates that significant actions — selling, leasing, financing — require the consent of all co-owners, rather than majority "management" that resembles a partnership.
Avoid a prearranged, binding sale at the moment of the drop. If a signed purchase and sale agreement already exists when the property is dropped, Court Holding makes the argument that the partnership was the real seller very hard to rebut.

There is also a compliance flag worth knowing about: Form 1065 asks, on Schedule B, whether the partnership distributed a tenancy-in-common or other undivided interest in property. A "yes" is effectively a drop-and-swap announcement to the IRS. That is not a reason to answer incorrectly — it is a reason to make sure the underlying facts are clean before you ever get there.

Strategy Three: Assigning a Partnership Installment Note to the Exiting Partner

Now to the variation the siblings found most appealing — and the one that solves the exiting partner's problem with real elegance. Recall that the third sibling wanted out but was in no hurry for all her money at once. That opens a door.

Suppose the buyer of the $3 million building is willing to pay part in cash and part with a seller-carried installment note — say $2 million in cash and a $1 million note. Here is how a split-up can be layered on top of that:

The partnership sells the building. The $2 million of cash flows into a §1031 exchange for the two continuing siblings (their two-thirds), acquiring replacement real estate and deferring their gain under §1031.
The $1 million installment note is distributed to the exiting sibling in liquidation of her one-third interest.

Why is that powerful? Because of how the code treats the distribution of an installment obligation by a partnership. Ordinarily, under §453B(a), disposing of an installment note triggers the deferred gain immediately. But a distribution of that note from a partnership to a partner is generally governed by the nonrecognition rule of §731 — it is not treated as a taxable disposition that accelerates the gain. Instead, the distributee partner steps into the partnership's shoes and continues to report the gain under the installment method of §453, recognizing it only as she actually collects the payments.

The result is remarkable: from a single sale, two owners defer tax through two entirely different mechanisms. The continuing siblings defer under §1031 because they reinvested in like-kind real estate. The exiting sibling defers under §453 because she took back a note and will report her gain over time as she is paid. Nobody is forced into a lump-sum tax bill in the year of sale.

There is also a valuable timing point that is easy to miss — and it means the note need not be a long, drawn-out obligation at all. Installment treatment under §453 requires only that at least one payment be received in a tax year after the year of sale. So the note can be structured for a very short horizon: the exiting partner receives an initial payment — in a real, more-than-nominal amount — immediately after the note has been distributed to her by the partnership (and never before the distribution, a point of sequence that is absolutely critical), with the balance maturing on January 2 of the following year for a calendar-year taxpayer. Because a payment falls in that later tax year, she still reports her gain on the installment method — but the deferral is compressed into a clean year-end-to-early-next-year window rather than stretched across a decade. Why does the sequence matter so much? If any payment is made before the note is distributed, that payment is received by the partnership, not the partner — which muddies the analysis and can defeat the very treatment the exiting partner is counting on. The note must be distributed first; the payments must come afterward.

A few cautions make this work in practice:

This is not §453B(h). That specific complete-liquidation exception is an S-corporation rule; for partnerships, the nonrecognition on a distributed note comes from §731 and the installment-reporting continuation under §453. The distinction matters, and the mechanics must be papered precisely.
Depreciation recapture cannot ride the note — §453(i). This is the single most important caveat, and it is easy to overlook. The installment method defers capital gain, but under §453(i) any depreciation recapture taxed as ordinary income under §1245 or §1250 must be recognized in full in the year of sale — it cannot be spread over the note. This matters enormously where the partnership took bonus depreciation (§168(k)) or other accelerated depreciation, often through a cost-segregation study that reclassified building components into 5-, 7-, and 15-year §1245 property. Every dollar of that accelerated depreciation comes back as §1245 ordinary-income recapture that the exiting partner must report up front, in the year of closing, regardless of the fact that she is being paid over time. Her share of that recapture is, in effect, un-deferrable. (The gain above recapture — including any 25% "unrecaptured §1250 gain" on real property depreciated straight-line — can still be reported on the installment method as she collects payments; it is specifically the §1245/§1250 recapture piece that §453(i) pulls into the year of sale.)
Watch the partnership "hot assets" — §751. Independently of §453(i), when a partnership distributes property or a note in a way that shifts the partners' shares of §751 "hot assets" — which include depreciation recapture and other ordinary-income items — §751(b) can force the exiting partner to recognize ordinary income on the distribution itself. Between §453(i) and §751, the recapture attributable to bonus and accelerated depreciation is essentially always going to be a current-year ordinary-income event for the withdrawing partner. The precise numbers are deal-specific and belong with her own CPA — but she should go in expecting to write a check on the recapture in the year of sale even while the balance of her gain rides the note.
Practice pointer — size the first note payment to cover the recapture tax. Because that recapture is a current-year tax bill no matter how the note is drafted, a sensible structuring move is to set the initial payment on the note at least equal to the tax the exiting partner will owe on her depreciation recapture. That way the cash she actually receives in the year of sale covers the check she has to write to the IRS for the recapture, and only the deferred capital gain rides the balance of the note. Her CPA should run the exact figure, but the principle is simple: don't leave her out of pocket on a tax the installment method was never going to defer.
The note cannot secretly be cash. If the note is immediately pledged, sold, or effectively turned into cash, the installment deferral collapses. It has to be a genuine deferred-payment obligation.
Interest must be stated. The note needs adequate stated interest under the imputed-interest rules, or the IRS will impute it.
Mind the two-partner termination trap. If the partnership has only two partners and one of them fully withdraws, the partnership drops to a single owner and terminates under §708 — it collapses into a disregarded entity, and that termination can itself be treated as a disposition that accelerates the very gain the note was meant to defer. The fix is simple but essential: the withdrawing partner should retain at least a de minimis interest so that two partners remain and the partnership continues in existence. (In our three-sibling example this is not a concern, because two siblings remain after the third exits — but in a true two-owner partnership it is critical.)

Done correctly, this is one of the most satisfying structures in the field: the partner who wants to keep investing does, the partner who wants to step away does, and neither one writes an unnecessary check to the IRS in the year of the sale.

A Worked Example

Return to the $3 million building, owned equally by three siblings ($1 million each), no debt, and assume for simplicity a low original basis so that most of the value is gain.

A buyer offers $3 million: $2 million cash plus a $1 million seller-carried installment note.
Siblings A and B (two-thirds) want to defer. Their $2 million share of the cash goes to a qualified intermediary and into 1031 exchanges. Each acquires replacement real estate of equal or greater value and reinvests all of their equity, deferring their entire gain under §1031.
Sibling C (one-third) wants out but does not need every dollar in the year of sale. The $1 million note is distributed to her in liquidation of her interest. She receives a real, more-than-nominal payment shortly after the note is distributed to her, with the balance maturing on January 2 of the following year. Because at least one payment falls in that later tax year, she reports her capital gain on the installment method of §453 — shifting the bulk of that tax into the next year rather than paying it all in the year of closing. One exception she cannot avoid: because the building was depreciated (and all the more so if the partnership used bonus depreciation or a cost-segregation study), her share of the §1245/§1250 depreciation recapture is ordinary income that §453(i) requires her to recognize in the year of sale — the note defers the capital gain, not the recapture. So we size that initial payment to at least cover the recapture tax, leaving her the cash to pay it without dipping into her own pocket. And because two siblings remain in the LLC after she exits, there is no §708 termination to worry about.

Three owners, one sale, and not one of them pays their full gain in the year of closing. That is what thoughtful structuring buys.

How This Fits With the Partner-Buyout Approach

There is a related strategy we have written about separately: when one co-owner wants to buy out the other and become the sole owner, Revenue Ruling 99-6 treats the buyer as acquiring the underlying real property, so the buyout itself can qualify as replacement property in the buyer's exchange — even though the same transaction is an ordinary taxable sale of a partnership interest for the person cashing out. If your situation is a buyout (one partner acquiring another's interest) rather than a split (the group going separate ways with an outside buyer), that is often the cleaner tool. We cover it in depth in our article, Buying Out Your Partner: How Acquiring an LLC Interest Can Qualify as Replacement Property in a 1031 Exchange.

The broader point is that there is no single "right" answer for a partnership that wants to split up. The drop-and-swap, the swap-and-drop, the installment-note assignment, and the Rev. Rul. 99-6 buyout are all tools in the same box. Which one fits depends on who wants cash, who wants to defer, whether an outside buyer is involved, and — always — how much time you have before a deal is signed.

A Washington Note

For owners here in the Puget Sound region, there is a state-level bright spot. Under Washington's capital gains tax, gains from the sale of real property are excluded (ESSB 6346 §302). So for a Tacoma or Pierce County partnership weighing these strategies, the planning above addresses the federal exposure without a competing Washington tax on the real estate gain itself. That is a meaningfully better starting position than partners face in a state like California, whose Franchise Tax Board scrutinizes drop-and-swap transactions aggressively.

The Takeaway — and the Timing

The thread running through every one of these strategies is timing. The drop-and-swap works best when the drop happens early — ideally in a prior tax year — and falls apart when it is jammed in the week of closing. The installment-note assignment has to be built into the purchase and sale terms before they are finalized. The Rev. Rul. 99-6 buyout has to be structured with the qualified intermediary in the chain from the start. In every case, the single most valuable thing a partnership can do is call a qualified intermediary before there is a listing, a buyer, or a signed purchase and sale agreement.

Once a binding contract is signed, most of these doors quietly close. Before that point, a partnership that wants to go separate ways has a genuinely elegant set of options — options that can let one partner defer under §1031, another defer under §453, and everyone walk away with the outcome they actually wanted.

If you and your co-owners are thinking about selling and suspect you may want different things from the proceeds, that is exactly the conversation to have early. We are always glad to talk it through before anything is listed or signed.

Jeff Helsdon, CES® Certified Exchange Specialist since 2003

Disclaimer: This article is for informational purposes only and does not constitute legal, tax, or financial advice. Every exchange has unique facts and circumstances. Consult your own attorney, CPA, and financial advisor before making decisions about your 1031 exchange.

Splitting Up a Partnership or LLC in a 1031 Exchange: Drop-and-Swap, Swap-and-Drop, and Assigning an Installment Note to the Exiting Partner