Investors often assume that if they own part of a real estate asset through a limited partnership (LP), they can use a 1031 exchange to defer capital gains taxes when the property is sold. Unfortunately, that’s not the case.

Under Internal Revenue Code §1031(a)(2)(D), interests in a partnership are explicitly excluded from 1031 exchange treatment. That means you cannot exchange a limited partnership interest for another piece of real property and defer taxes. Even if the LP owns nothing but real estate, your interest is still considered personal property and not like-kind to real estate.

But that doesn’t mean you’re stuck with enormous capital gains and no options, especially in local areas like Newport Beach with sky-high appreciation. With proper planning, there are viable workarounds that allow individual LP members to reposition into direct real estate ownership and complete a valid 1031 exchange.

Why It Matters

Limited partnerships and LLCs taxed as partnerships have been a popular way to pool investor capital for decades. They offer liability protection and pass-through taxation—an efficient setup for many real estate deals. But when it’s time to sell the asset, complications arise if one or more partners want to cash out and others want to roll proceeds into a new property via 1031 exchange.

In these cases, the challenge is converting ownership of the entity into direct ownership of real estate without triggering a taxable event or violating 1031 rules.

The “Drop and Swap” Strategy

One common workaround is the “Drop and Swap.”

• Before the sale, the partnership distributes the real estate to the partners in proportion to their ownership.
• Each partner becomes a tenant in common (TIC) owner of a direct interest in the real estate.
• Those who want to do a 1031 exchange can now sell their TIC interest and proceed with a properly structured exchange.

However, this structure comes with IRS scrutiny and tax risks:

• Short-lived TIC ownership can trigger denial based on lack of intent to hold for investment.
• The step-transaction doctrine may apply, collapsing the structure into a taxable event.
• If the TIC acts like a partnership, the IRS could recharacterize it as a disguised partnership.

Best Practices for Drop and Swap

• Avoid prearranged sales – no contracts before the drop.
• Allow ample time between drop and sale if possible.
• Formally dissolve the partnership.
• Ensure passive co-ownership and separate accounting.
• Discuss with a legal and tax professional to ensure to address all risks and concerns.

Other Strategic Options

• Distribute only to cash-out partners to preserve exchange eligibility for others.
• IRC §708(b)(2) partnership division to align goals across newly formed entities.
• Buy out retiring partners before or after the exchange using refinancing strategies.
• Installment note redemption structures to defer taxes on redemption of LP interests.
• Swap and drop method: hold property post-exchange before distributing TIC interests.

Each of these options requires careful planning and experienced guidance to avoid costly mistakes.

Why This Matters to Investors and Trustees

If you’re managing an estate, trust, or investment partnership with diverging goals, don’t assume you can “1031 out” of a partnership. You need legal and tax professionals who understand both entity law and real estate strategy.

Our Expertise

At Lucas Real Estate Group, we combine real estate sales, tax strategy, and legal structuring under one roof. Led by Devin R. Lucas, a REALTOR®, Real Estate Attorney, and Real Estate Broker, we help property owners, trustees, and investors navigate the complexities of real estate transactions, including 1031 exchanges.

We specialize in Newport Beach, Costa Mesa, and surrounding Orange County coastal communities, offering confidential representation for high-net-worth individuals, trustees, and sophisticated investors.

Questions or Need Help?

Thinking of selling California real estate? We’d love the opportunity to assist – we provide full-service sales and property management in Newport Beach, Costa Mesa and surrounding areas. Call or email anytime: [email protected] or 949-478-1623.

Author Devin R. Lucas is a Real Estate Broker, REALTOR®, and Real Estate Attorney specializing in Newport Beach, Costa Mesa, and Orange County coastal communities. Courtney Lucas, a licensed CPA, Real Estate Salesperson, and REALTOR®, provides expert financial insight alongside real estate services.

Lucas Real Estate offers unmatched expertise in California real estate sales, property management, capital gains strategies, and property tax matters, including Propositions 13, 58, 193, 60, 90, and new Proposition 19.

Contact Us:
[email protected] | 949.478.1623

Lucas Real Estate is a full-service brokerage offering residential real estate, legal services, and strategic tax planning—all under one roof.