Investors often assume that if they own part of a real estate asset through a limited liability company (LLC), 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 — which includes most multi-member LLCs — are explicitly excluded from 1031 exchange treatment. That means you cannot exchange an LLC membership interest for another piece of real property and defer taxes. Even if the LLC holds nothing but real estate, your membership is still considered personal property, not a like-kind real estate interest. 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 LLC members to reposition into direct real estate ownership and complete a valid 1031 exchange.Learn how LLC members holding real estate can navigate 1031 exchange restrictions with strategic planning—especially in high-appreciation markets like Newport Beach. (FYI — this is the same problem and discussion as with ownership in limited partnerships. See our LP-specific article here.)
Why It Matters
LLCs taxed as partnerships have long been a popular way to pool investor capital. 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 members 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 LLC distributes the real estate to its members in proportion to their ownership.
- Each member 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 (6–12 months recommended).
- Formally dissolve the LLC or document TIC conversion clearly.
- Ensure passive co-ownership and separate accounting.
- Consult with a legal and tax professional to address all risks and compliance requirements.
Other Strategic Options
- Distribute only to cash-out members to preserve exchange eligibility for others.
- IRC §708(b)(2) partnership division to realign goals across newly formed entities.
- Buy out retiring members before or after the exchange using refinancing strategies.
- Installment note redemption structures to defer taxes on redemption of LLC interests.
- Swap and drop method: hold property post-exchange before distributing TIC interests.
Each of these options requires thoughtful planning and experienced guidance to avoid costly missteps.
Exception: Single-Member LLCs (SMLLCs)
There is one key exception: a single-member LLC (SMLLC) is treated as a disregarded entity for federal tax purposes.
That means:
- The individual owner is the taxpayer for 1031 purposes.
- The SMLLC can buy and sell property in a 1031 exchange with no workaround needed.
This makes SMLLCs a very flexible ownership structure for real estate investors planning future exchanges.
Summary
- LLC taxed as partnership — ❌ 1031 exchange not allowed for membership interests → use same drop/swap workarounds.
- LLC taxed as corporation — ❌ Not eligible, and may trigger corporate-level taxation.
- SMLLC (disregarded entity) — ✅ Fully eligible for 1031 exchanges, provided the same individual remains the taxpayer.
What About LPs?
All of the same challenges and workarounds discussed here apply to real estate held in limited partnerships (LPs) as well. An LP interest is also personal property and excluded from 1031 exchange treatment. See our companion article focused on LPs here.
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.
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