Understanding §1031 Exchanges: “Swap and Drop” vs. “Drop and Swap”

Some real estate advi­sors are antic­i­pat­ing the over­all mar­ket to improve, cre­at­ing a pipeline of real estate trans­ac­tions in the sec­ond half of 2025.  Antic­i­pat­ing this increase, investors who own real estate with oth­er investors need to under­stand exit strate­gies when there are dif­fer­ent goals and objec­tives of the indi­vid­ual investors.

March 20, 2025

By Al DiNi­co­la, AIF®
§1031 Tax Deferred Exchange Spe­cial­ist & DST Advi­sor
NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC
Secu­ri­ties offered through MSC-BD, LLC, Mem­ber of FINRA/SIPC

Intro­duc­tion

We con­tin­ue to have com­ments on our pre­vi­ous post on a vari­ety of top­ics. The con­ver­sa­tions late­ly have includ­ed §1031, Delaware Statu­to­ry Trust, Oppor­tu­ni­ty zones and more when nav­i­gat­ing the tax defer­ral oppor­tu­ni­ties. As a savvy real estate investor, you’re well aware of the tax ben­e­fits that §1031 exchanges offer. These pow­er­ful tools allow you to defer cap­i­tal gains tax­es when sell­ing one invest­ment prop­er­ty and acquir­ing anoth­er like-kind prop­er­ty. How­ev­er, the intri­ca­cies of deal­ing with part­ner­ships and LLCs can be as com­plex as nav­i­gat­ing a mul­ti-sto­ry com­mer­cial build­ing. In this com­pre­hen­sive arti­cle, we’ll delve into two spe­cif­ic strate­gies: the “swap and drop” and the “drop and swap.” Under­stand­ing the dis­tinc­tions and appli­ca­tions of these strate­gies is cru­cial for mak­ing informed deci­sions that align with your invest­ment goals. It may be some­what con­fus­ing because the ter­mi­nol­o­gy seems sim­i­lar.

1. §1031 Exchanges (Cliff Notes)

If you can remem­ber Cliff Notes you may be in the right demo­graph­ics to sell active real estate and move into a pas­sive own­er­ship. Here are the notes or the fun­da­men­tal prin­ci­ples of §1031 exchanges. These trans­ac­tions allow investors to sell a prop­er­ty and rein­vest the pro­ceeds into anoth­er prop­er­ty of equal or greater val­ue, all while defer­ring cap­i­tal gains tax­es. The key require­ment is that the replace­ment prop­er­ty must be of like kind (e.g., com­mer­cial real estate for com­mer­cial real estate). It’s impor­tant to note that ‘like-kind’ refers to the nature and char­ac­ter of the prop­er­ty, rather than its grade or qual­i­ty, allow­ing for a broad range of invest­ment oppor­tu­ni­ties.

2. The Chal­lenge with Part­ner­ship LLCs

Lim­it­ed lia­bil­i­ty com­pa­nies (LLCs) are a pop­u­lar choice for real estate invest­ments due to their pass-through tax­a­tion and flex­i­bil­i­ty. How­ev­er, when it comes to §1031 exchanges, part­ner­ship LLCs pose unique chal­lenges. Part­ner­ship inter­ests mean that each part­ner holds an own­er­ship inter­est. But what hap­pens when some part­ners want to cash out while oth­ers pre­fer to con­tin­ue defer­ring tax­es through a §1031 exchange? It’s akin to try­ing to nego­ti­ate lease terms with a diverse group of tenants—everyone has dif­fer­ent pri­or­i­ties. Nav­i­gat­ing these chal­lenges requires strate­gic plan­ning, often lead­ing investors to con­sid­er ‘swap and drop’ or ‘drop and swap’ strate­gies.

3. The “Drop and Swap” Strat­e­gy

What Is It?

In a “drop and swap,” part­ners first per­form a finan­cial bal­let by con­vert­ing their own­er­ship struc­ture from an “enti­ty lev­el” (the LLC) to a co-own­er­ship arrange­ment (ten­ants in com­mon or TIC). Next, the prop­er­ty is sold, and the pro­ceeds are divid­ed pro­por­tion­al­ly among the co-own­ers. Co-own­ers can choose to cash out and pay tax­es or rein­vest in anoth­er prop­er­ty through a qual­i­fied inter­me­di­ary (QI) while still defer­ring tax­es. Sim­ply put, this strat­e­gy involves restruc­tur­ing own­er­ship from a col­lec­tive LLC to indi­vid­ual own­er­ship before pro­ceed­ing with the exchange.

Is It Legal?

Yes, the “drop and swap” strat­e­gy is legal. It allows part­ners to main­tain the ben­e­fits of a §1031 exchange while adjust­ing their own­er­ship struc­ture. Tak­ing the steps to accom­plish this will poten­tial­ly save tax­es for some investors.  We would also sug­gest to have the right doc­u­men­ta­tion com­plet­ed ahead of the sale.

4. The “Swap and Drop” Strat­e­gy

What Is It?

There is anoth­er option. Part­ners start with the exist­ing LLC own­er­ship struc­ture. The prop­er­ty is sold, and the entire LLC sells the relin­quished prop­er­ty in one grand swoop. Part­ners then pur­chase the replace­ment prop­er­ty togeth­er, con­tin­u­ing to defer tax­es as long as the LLC remains intact. In more straight­for­ward terms, the “swap and drop” keeps the LLC struc­ture intact through­out the exchange process, enabling part­ners to act togeth­er.

Is It Legal?

Absolute­ly. Sec­tion §1031 requires that exchanges of part­ner­ship prop­er­ty be han­dled by the same tax­pay­er. As long as the LLC com­po­si­tion remains unchanged, the “swap and drop” approach is com­pli­ant. It’s like exe­cut­ing a flaw­less aer­i­al maneu­ver with­out miss­ing a beat.

5. Which Strat­e­gy Should You Choose?

The deci­sion between “swap and drop” and “drop and swap” depends on your spe­cif­ic cir­cum­stances. “Drop and Swap” is ide­al when part­ners want to change their own­er­ship struc­ture and main­tain §1031 exchange ben­e­fits. “Swap and Drop” is suit­able when part­ners pre­fer to keep the exist­ing LLC intact and defer tax­es col­lec­tive­ly. While choos­ing a strat­e­gy, con­sid­er poten­tial risks and con­sult with pro­fes­sion­als to under­stand the impli­ca­tions ful­ly.

Con­clu­sion

Both strate­gies offer solu­tions for nav­i­gat­ing the com­plex­i­ties of part­ner­ship LLCs dur­ing §1031 exchanges. The nuances of each approach require care­ful con­sid­er­a­tion and a deep under­stand­ing of the partnership’s goals and indi­vid­ual cir­cum­stances. While these strate­gies offer inno­v­a­tive solu­tions, the com­plex­i­ties of §1031 exchanges and part­ner­ship dynam­ics neces­si­tate per­son­al­ized advice from tax and legal pro­fes­sion­als to nav­i­gate suc­cess­ful­ly. Con­sult with your tax advi­sor and legal coun­sel to deter­mine the best approach for your invest­ment goals.

 If the investors wish to go in dif­fer­ent direc­tions mean­ing some investors uti­liz­ing a tra­di­tion­al 1031 exchange and oth­ers seek­ing a more pas­sive invest­ments such as DST, the for­mer strat­e­gy is prefer­able.  That would be to get the legal work com­plet­ed in the Drop and Swap. DST (or TICs) by design have longer invest­ment time peri­ods. This would pre­vent any quick actions. In addi­tion, some investors who are required to replace debt enjoy the non-recourse debt assign­ment in the DST struc­ture.

NAMCOA® is a SEC reg­is­tered invest­ment advi­so­ry firm that pro­vides com­pre­hen­sive port­fo­lio man­age­ment, finan­cial plan­ning, and fidu­cia­ry deci­sion-mak­ing ser­vices on behalf of retire­ment plan spon­sors. Our Dif­fer­ence is sum­ma­rized by our fidu­cia­ry approach which enables us to bet­ter meet port­fo­lio and retire­ment plan objec­tives, result­ing in stronger risk adjust­ed returns for investors and peace of mind for Clients. We also focus on alter­na­tive real estate invest­ment. Many real estate investors are seek­ing tax deferred solu­tions uti­liz­ing §§1031 exchanges or Oppor­tu­ni­ty Zones.

DSTs are not for all investors.  The acqui­si­tion of a DST is for accred­it­ed investors only.  Con­tact your invest­ment advis­er for addi­tion­al details on how a DST may be a solu­tion to your §§1031 Exchange and suit­ed for your invest­ment future. For more infor­ma­tion on how to prop­er­ly set up an IRC §§1031 Tax Deferred Exchange or if you are an accred­it­ed investor and would like addi­tion­al infor­ma­tion on a DST con­tact Al DiNi­co­la at 239–691-8098 or email adinicola@namcoa.com.

This is not an offer to pur­chase or solic­i­ta­tion to pur­chase any secu­ri­ty, as such be made only through an offer­ing mem­o­ran­dum or prospec­tus.  Invest­ing in secu­ri­ties, real estate, or any invest­ment, whether pub­lic or pri­vate, involves risk, includ­ing but not lim­it­ed to the poten­tial of los­ing some or all of your invest­ment dol­lars when you invest in secu­ri­ties. You should review any planned finan­cial trans­ac­tions that may have tax or legal impli­ca­tions with your per­son­al tax or legal advi­sor.   NAMCOA, LLC is a Reg­is­tered Invest­ment Advi­sor, reg­u­lat­ed by SEC (Secu­ri­ties and Exchange Com­mis­sion). Our cor­po­rate office is locat­ed at 999 Van­der­bilt Beach Road, Suite 200, Naples Flori­da 34108. Secu­ri­ties Offered through MSC-BD, LLC, Mem­ber of FINRA/SIPC. 5 Cen­ter­pointe Dri­ve, Ste. 400 Lake Oswego, OR, 97035. MSC-BD, LLC and NAMCOA are inde­pen­dent­ly owned and are not affil­i­at­ed.

Thank you.