Drop and Swap: Still One of the Most Powerful Tools in a 1031 Exchange

When partners own real estate together, they do not always want the same outcome when it is time to sell. One may want to reinvest. Another may want a different asset class. Another may be done altogether.

That is exactly where the drop and swap comes in.

Despite years of scrutiny from state taxing authorities, drop and swap transactions remain one of the most flexible and effective planning tools available when structured properly. And a New York Tax Court decision has added further support to what exchange professionals have relied on for decades.

What Is a Drop and Swap?

At its core, a drop and swap is about flexibility.

A partnership distributes real property to its partners as tenants in common. That is the “drop.”

Each partner then decides what to do with their individual interest. Some complete a 1031 exchange into replacement property. Others sell and recognize gain. That is the “swap.” This approach allows partners to go separate directions without forcing everyone into the same tax or investment decision.

Why Drop and Swap Matters

In the real world, partnerships change. Investment goals evolve. Life happens. The drop and swap allows those changes to happen without blowing up an otherwise valid exchange.

For years, the primary concern has not been federal law. The IRS has long acknowledged drop and swap transactions when correctly structured. The friction has largely come from state taxing authorities questioning holding periods, ownership, and intent.

That is why the New York decision matters.

New York Case Confirms What Exchange Professionals Already Knew

In the Matter of the Petition of Benjamin Hadar and Rachel Hadar and Ruth Shomron, the New York Division of Tax Appeals addressed a classic drop and swap scenario involving long held real estate, multiple partners, and very different goals at the time of sale. Some partners completed a 1031 exchanges. One partner cashed out. The distribution to tenants in common and the sale occurred on the same day.

New York challenged the exchanges. The state argued that the tenants in common did not hold the property long enough and that the partnership itself was the true seller.

The Administrative Law Judge disagreed across the board.

The court confirmed that:

• There is no minimum holding period required under a 1031.Intent to exchange matters more than the length of ownership.
• The traditional “benefits and burdens” ownership test does not control in a 1031 context.
• Properly documented distributions to tenants in common are respected when the individuals are clearly the sellers.
• Reliance on experienced a 1031 counsel is a meaningful factor, including when penalties are considered.

The result was a full win for the taxpayers, with millions in proposed taxes and penalties eliminated.

Why This Matters Beyond New York

This decision aligns New York with well-established federal case law, including Bolker, Mason, and Magneson. It also draws a clear distinction from more aggressive states, such as California, where drop and swap transactions have faced increased resistance based on timing and form.

While no case eliminates scrutiny entirely, the Hadar decision reinforces a simple point: drop and swaps are valid when done correctly.

How to Structure a Strong Drop and Swap in Real Estate

Even with supportive case law, execution matters. The strongest drop and swap transactions tend to share common characteristics:

Clear intent to exchange property.

Intent should exist before the sale, not after. Contemporaneous documentation helps.

Early involvement of exchange professionals.

Courts notice when taxpayers seek qualified a 1031 guidance in advance.

Individuals are clearly the sellers.

Purchase contracts, deeds, and closing statements should reflect the tenants in common, not the partnership.

Properly executed distributions.

 Deeds must be recorded and required transfer tax filings completed.

Correct allocation of proceeds.

 Proceeds should follow deeded ownership interests, even if they differ from prior partnership allocations.

Form 7217 compliance.

Beginning in 2024, partners receiving property distributions must file IRS Form. This is now part of every drop and swap checklist.

The Bottom Line

Drop and swap transactions have always been about practical problem solving. When partners want different outcomes, this strategy allows each investor to move forward on their own terms.

The New York decision does not create new law. It confirms existing principles and reinforces that substance, structure and intent matter more than artificial timing rules.

For clients facing partnership transitions, drop and swap remains one of the most effective tools available in a 1031 toolbox when handled correctly.

If you are considering a drop and swap or advising clients through a partnership sale, Asset Preservation, Inc. team members can discuss and help you implement structure, risks and best practices.

Learn more about Asset Preservation, Inc. and connect with their team.