Partnership issues in a 1031

Here is the scenario that breaks up real estate partnerships at exit. Three partners own a building through an LLC. It has appreciated enormously. Two want to cash out; one wants to 1031 into a new property. They cannot simply each do what they want, because of one unforgiving rule: a partnership interest is not like-kind to real estate, and cannot be exchanged. This is the most common and most painful 1031 problem, and understanding it is the setup for the drop-and-swap solutions that follow.

The rule: the entity can exchange, the partners cannot

A partnership that owns real estate can absolutely do a 1031 exchange. The LLC sells its property and the LLC buys a replacement, deferring the gain at the entity level. That part works fine.

The problem is the partners. The tax code explicitly excludes partnership interests from 1031: you cannot exchange your interest in a partnership for real estate, because a partnership interest is not like-kind to real property. So an individual partner cannot take their share of the proceeds and 1031 it into their own replacement property. The exchange belongs to the partnership as a whole, not to the partners individually. If the partnership exchanges, everyone goes along into the same replacement; if it sells and distributes cash, everyone is taxed.

A partnership can exchange its property, but a partner cannot exchange their partnership interest, so the partners cannot each take their share and go their own way in a 1031.

Why this wrecks exits

The rule collides head-on with the most common exit situation: partners who no longer want the same thing. When a deal winds down, some partners want cash, some want to keep deferring, some want to reinvest in different properties. The 1031 rule forces an all-or-nothing choice at the entity level: either the whole partnership exchanges into one replacement together, or it sells and everyone pays tax. There is no clean way, within a straight 1031, for the partners to split up and each pursue their own tax strategy.

This is not a rare edge case; it is the default fate of successful real estate partnerships. The building appreciated, the partners’ lives diverged, and the tax code will not let them separate on their own terms inside a 1031. The frustration this causes is exactly what the workaround structures were invented to relieve.

The rule forces an all-or-nothing exit: the whole partnership exchanges into one property together, or it sells and everyone is taxed, with no way for partners to split inside a straight 1031.

The workarounds, and where they lead

Because the problem is so common, practitioners developed two mirror-image structures to give partners flexibility, both covered on their own pages.

Drop-and-swap distributes the property out of the partnership to the partners as tenants in common before the sale, converting each partner into a direct co-owner of real estate. Now each former partner holds real estate, not a partnership interest, so each can independently 1031 into their own replacement or cash out, as they choose. The mirror image, swap-and-drop, has the partnership complete the exchange first and then distribute interests in the replacement property to partners who want out. Both aim at the same goal, letting partners go separate ways, and both carry a timing and intent risk the IRS scrutinizes, because they convert a partnership interest into real estate right around the exchange, which can look like exactly the maneuver the rule was meant to prevent.

The fix is to convert partnership interests into direct real estate ownership before or after the exchange, via drop-and-swap or swap-and-drop, so each partner holds exchangeable real estate.

The bottom line

• A partnership can do a 1031 exchange at the entity level, deferring gain for all partners together.
• A partnership interest is not like-kind to real estate, so individual partners cannot exchange their shares.
• Partners who want different exits cannot each pursue their own 1031 inside the partnership.
• The workarounds, drop-and-swap and swap-and-drop, convert interests into direct real estate ownership.
• The IRS scrutinizes these for genuine investment intent and timing, so they require advance planning.

For the main solution, read drop and swap. For the mirror-image approach, see swap and drop. For the most defensible split, see partnership division (708 spin-off). For the full picture, start at the 1031 exchanges and exit planning hub.

Last verified August 2026.