Drop-and-Swap After Partnership Dissolution: Legitimate Restructuring or Integrated Sale?

Very High

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🏢 Client

We're looking at selling a commercial property in Austin that's held in an LLC taxed as a partnership — my family owns 60%, and two other investors own 20% each. The property is worth about $15 million with a $4 million basis, so we're sitting on an $11 million gain. Here's the issue: I want to do a 1031 exchange into replacement property that only I will own going forward, but my co-investors jus…

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Case Summary ▾

Complexity ⓘ Very High

Fact Pattern Family and co-investors held appreciated commercial property ($15M FMV, $4M basis) in partnership-taxed LLC. Majority partner sought to 1031 exchange into individually-owned replacement property while minority partners wanted cash liquidity. Partnership executed formal dissolution distributing property to majority partner and cash to minority partners, followed 60 days later by majority partner's individual Section 1031 exchange into pre-identified Dallas replacement property.

Position Taken Drop-and-swap structure is defensible under Revenue Ruling 99-6 Situation 1 where partnership undergoes complete liquidation for legitimate business reasons (divergent investment strategies documented over six-month period), majority partner receives property in tax-free Section 731 distribution, minority partners receive cash in liquidating distributions, and 60-day waiting period between distribution and commencement of individual exchange provides sufficient separation to avoid step-transaction recharacterization. Business purpose for dissolution—partner divergence on hold-versus-sell strategy and liquidity preferences—existed independently of tax planning and was documented in contemporaneous partnership discussions. Partnership resolution cited divergent investment objectives without reference to contemplated 1031 exchange. Structure approved with explicit 60-90 day waiting period recommendation and requirement that no replacement property contracts be executed prior to formal exchange commencement.

IRS Challenge Step-transaction doctrine applies to collapse distribution and exchange into integrated partnership-level sale where taxpayer's statements establish replacement property was identified months before distribution, co-investors had clear expectation of cash exit, 60-day waiting period was deliberate tax-planning buffer rather than genuine business indecision, and dissolution would not have occurred but for desire to achieve individual exchange treatment while cashing out non-exchanging partners. Revenue Ruling 99-6 safe harbor inapplicable where distribution and exchange are component parts of prearranged plan rather than independent decisions. Transaction should be recharacterized as partnership sale with impermissible differential treatment (deferral for one partner, boot to others), disallowing Section 1031 treatment entirely and recognizing full gain on distribution with 20% accuracy-related penalties under Section 6662(a) for proceeding despite explicit awareness of step-transaction exposure.

Authorities

IRC § 1031(a) IRC § 731 IRC § 707 IRC § 6662(a) Treas. Reg. § 1.1031(a)-1(a)(1) Treas. Reg. § 1.1031(k)-1(c)(4) Revenue Ruling 99-6