In a "drop and swap," a partnership distributes the property to partners as tenants-in-common who then exchange on their own; in a "swap and drop," the partnership exchanges first and later distributes the replacement property to partners who want out. Both draw IRS scrutiny under the step-transaction doctrine, which lets the agency judge a series of steps by their substance rather than their form. A restructuring done well before the sale, for documented business reasons, is far easier to defend.
A partnership owns a property, and it is time to sell. Some of the partners want to take the cash and be done. Others want to roll the gain into a new property through a 1031 exchange, the rule that lets real estate owners defer capital-gains tax by reinvesting the proceeds in like-kind property. One sale, two incompatible plans.
Some advisors suggest a fix: restructure the ownership so each partner can act independently. "Drop and swap" and "swap and drop" are the two sequences that come up most often. Both carry meaningful risk under the step-transaction doctrine, and both call for legal planning well before any sale.
What "drop and swap" means
In a drop and swap, the partnership distributes - drops - the property to the individual partners as tenants-in-common, each holding a separate, undivided share. The partnership dissolves, or the property leaves it. The partners, now holding those separate interests, sell. Each then decides on their own whether to do a 1031 exchange or take the cash.
Restructure first, then sell.
What "swap and drop" means
In a swap and drop, the order flips. The partnership sells the property and completes the 1031 exchange itself, buying the replacement property in the partnership's name. Once the exchange is done, it distributes that replacement property to the individual partners.
Exchange first, then distribute.
Why the IRS looks past the labels
The IRS has no rule that bans either sequence. Its objection runs through the step-transaction doctrine, which lets the agency look past the formal steps of a series of transactions and recharacterize them based on their substance.
Say a partnership converts to tenant-in-common ownership right before a sale, and the only reason for the change is to let partners exchange on their own. The IRS may treat the conversion as a sham and view the partnership itself as the seller. If it does, the individual exchanges by the former partners are disqualified.
Swap and drop invites the mirror argument. If the partnership exchanges and then immediately distributes the replacement property so partners can go their separate ways, the IRS may argue the distribution was the plan all along, and judge the exchange on that basis.
Either way, the question is the same: was the restructuring a genuine business decision, or a tax-motivated step meant to reach a result the rules would not otherwise allow?
What raises the risk
Timing. The closer the restructuring sits to the sale, the more it looks like one coordinated plan. A drop that happens days or weeks before the property is listed is hard to defend. A restructuring done 18 months earlier, for documented business reasons, is far easier.
No independent business purpose. If the only stated reason for restructuring is "so partners can exchange independently," that is a tax purpose, and the IRS gives less deference to a change driven entirely by tax.
No operational change. If the partners restructure on paper but nothing changes about how the property is managed, insured, financed, or run, the restructuring looks cosmetic.
What lowers it
Each of those has a mirror.
Time. Twelve months or more of operating under the new structure before the property is listed puts real distance between the restructuring and the sale. Time does more to defuse a step-transaction argument than any other factor. A restructuring written into the partnership agreement from the start - a sunset provision, a planned exit date, an agreed timeline - is more defensible still, because following a pre-existing plan is easier to explain than reacting to a pending sale.
Documented reasons. Minutes, resolutions, or correspondence showing the change was driven by operational independence, succession planning, or dispute resolution, rather than tax alone, strengthen the position.
Real operational change. When the co-owners actually begin managing their interests separately, buying their own insurance, or making their own capital decisions, the restructuring looks substantive rather than cosmetic.
Simpler alternatives
Restructuring is not the only way through a disagreement, and a plainer path can avoid the step-transaction problem entirely.
Partner buyout. One partner buys out the other before the sale. The remaining owner sells and exchanges alone. No restructuring, no step-transaction risk.
Shared exchange. Both partners agree to exchange. The partnership buys the replacement property, and the partner who wants out takes distributions over time or negotiates a future buyout.
Property partition. If the property can be split into separate legal parcels, each partner takes a parcel and decides on their own whether to exchange. This is logistically complex, but it sidesteps the step-transaction issue.
Accept the mismatch. If the tax the exchange would defer does not justify the legal cost and risk of restructuring, one or both partners may simply sell and pay the tax.
When swap and drop is easier to defend
Swap and drop is generally seen as lower risk than drop and swap when the partnership genuinely meant to hold the replacement property and the distribution comes well after the purchase. A partnership that buys replacement property, operates it for a meaningful period, and later distributes it for a legitimate reason - a partner retiring, a dispute, estate planning - has a sequence that is easier to defend.
If the plan from day one was "exchange now, distribute immediately," the same concerns return. The IRS weighs the whole plan, not the label on each step.
Why this needs a professional
Drop and swap and swap and drop sit where partnership tax law, 1031 regulations, and the step-transaction doctrine meet. The analysis is specific to each set of facts: what works for one partnership can fail for another on timing, documentation, and intent alone.
Anyone weighing either strategy should engage a tax attorney or CPA experienced with partnership restructurings before taking any action, and not attempt a last-minute restructuring without professional guidance. The cost of getting it wrong - full taxation of the gain plus interest and potential penalties - far exceeds the cost of planning it properly.
Both sequences turn on facts the IRS can second-guess: how close the restructuring sat to the sale, how well it was documented, and whether anything real changed. The paths that hold up best tend to share one feature, distance between the restructuring and the sale, and the law here is specific enough that these decisions are generally worked out with a tax attorney or CPA before anyone acts.
Frequently asked questions
What is "drop and swap"?
Drop and swap is a strategy where a partnership distributes the property to its partners as tenants-in-common - the "drop" - and each partner then runs their own 1031 exchange - the "swap." Separating the property before the sale is what lets each partner exchange or cash out on their own.
What is "swap and drop"?
Swap and drop reverses the order. The partnership completes the 1031 exchange first - the "swap" - and buys the replacement property. Then it distributes that replacement property to the partners who want to cash out - the "drop."
Why does the IRS scrutinize these strategies?
Because of the step-transaction doctrine, which lets the IRS treat a series of steps taken toward one goal as a single transaction and recharacterize them. If a partnership drops the property to its partners and immediately lists it, the arrangement looks like an attempt to sidestep the rules that apply to the entity. Timing and intent are what the IRS weighs.
How long should I wait before selling after a drop and swap?
There is no bright-line rule, but more time helps. Many professionals suggest 12 or more months between the drop and the sale, to show the drop was a genuine restructuring rather than a step toward selling. A drop followed by a sale within weeks draws heavy scrutiny.
What's the safest way to handle disagreement between partners on exchanging?
The approach professionals tend to describe as safest is restructuring early, 12 or more months before an expected sale, by converting to tenant-in-common ownership or separate entities and documenting the business reason for the change. By the time of the sale, each partner's status as an exchanger or a non-exchanger is already clear, and that time and distance is what undercuts a step-transaction argument.