1031 Exchange Strategies: Buying Partnership or LLC Interests vs. Direct Real Estate

When structuring a 1031 exchange, one question often arises: Can you acquire partnership or LLC membership interests instead of buying real estate directly?

It’s a smart question, and a common point of confusion. Many investors participate in partnerships, joint ventures or limited liability companies that own real estate, and it’s natural to assume that exchanging one type of ownership interest for another might qualify for tax deferral. However, the IRS draws a sharp distinction between owning property directly and owning an interest in an entity that owns property. While both can be valuable investments, only one qualifies as “like-kind” real estate under Section 1031.

Understanding the Basics: What the IRS Considers “Like-Kind” Property

For an exchange to qualify for tax deferral, the property you sell and the property you purchase must both be real property held for investment or business purposes. The IRS defines “real property” broadly — it can include land, buildings, improvements and even certain leasehold interests, as long as they’re held for productive use in a trade, business or investment.

However, this definition does not extend to ownership interests in entities such as partnerships, corporations or multi-member LLCs. When you buy or sell an ownership interest in a company that holds real estate, you’re not exchanging the property itself; you’re exchanging a security or ownership share in the entity. That distinction makes the transaction ineligible for 1031 treatment.

By contrast, direct ownership, where you hold title to the property in your own name or through a disregarded entity (such as a single-member LLC), fully qualifies. The key is that the taxpayer involved in the exchange must be the same person or entity that holds title to the relinquished and replacement properties. This distinction forms the foundation for how the IRS evaluates 1031 exchanges and why partnership or LLC interests often fall outside the scope of allowable like-kind property.

Why Partnership or LLC Interests Usually Don’t Qualify

At first glance, buying an interest in a partnership or LLC that owns real estate would appear to meet qualification standards for a 1031 exchange. After all, the underlying asset is still real property. However, the IRS takes a very different view.

Under Section 1031(a)(2)(D) of the Internal Revenue Code, partnership and LLC membership interests are explicitly excluded from like-kind exchange treatment because these interests are considered personal property or securities, not real property. When you own a share of an entity, you’re investing in the company itself, not directly in the real estate it owns.

For example, if you sell a warehouse that you personally own and use the proceeds to buy a 25% membership interest in an LLC that owns an apartment building, the IRS won’t view that as a property-for-property exchange. Instead, it’s a property-for-equity transaction, which means it falls outside the scope of Section 1031.

This rule often surprises investors involved in joint ventures or real estate partnerships. Even if your name appears on the LLC’s operating agreement or you’ve contributed capital toward property ownership, you’re still exchanging an ownership interest, not the underlying real estate. Because of this, exchanges involving partnership or LLC interests require special planning to preserve tax-deferral benefits, often through restructuring before or after the exchange, as we’ll explore in the next section.

Alternative Strategies: “Drop and Swap” and “Swap and Drop”

When partnership or LLC interests can’t qualify directly for a 1031 exchange, investors often turn to creative (but compliant) structuring options to make tax deferral possible. Two of the most common are the “drop and swap” and “swap and drop” strategies.

Drop and Swap

In a “drop and swap,” a partnership or LLC distributes ownership of the underlying real estate directly to individual partners or members before the exchange. Each owner receives their proportional interest as a tenant in common (TIC), effectively converting their entity interest into direct ownership of real property.

Once this step is complete, each partner can independently decide whether to participate in a 1031 exchange. For example, one partner might exchange their interest for a new property, while another may cash out and recognize the gain.

However, this approach must be carefully timed and documented. If the IRS determines that the distribution occurred solely to facilitate a quick exchange, it may challenge the transaction on the grounds that the property wasn’t held for investment. To mitigate this risk, many tax professionals recommend holding the property for a period after the distribution before proceeding with the exchange.

Swap and Drop

The reverse approach, known as a “swap and drop,” involves completing the 1031 exchange first and then restructuring ownership afterward. In this scenario, the entity sells the relinquished property and acquires the replacement property under the partnership or LLC’s name. Once the exchange is complete and the IRS timelines have passed, the entity may distribute ownership interests to its partners or members.

While this strategy may reduce immediate scrutiny, it still carries potential risks if the IRS believes the entity was restructured primarily for tax avoidance. Like the “drop and swap,” it requires careful coordination between your tax advisor, attorney and qualified intermediary (QI) to maintain compliance.

Both methods can provide paths to partial or full tax deferral, but they demand precise planning and documentation. The safest route is to work closely with experienced professionals who understand how to navigate these complex ownership structures under Section 1031.

Exploring Other Investment Structures

While partnership or LLC interests themselves don’t qualify for 1031 treatment, several alternative structures allow investors to achieve similar goals without violating IRS rules. The most common are Tenant-in-Common (TIC) ownership and Delaware Statutory Trusts (DSTs).

Tenant-in-Common (TIC) Interests

A TIC arrangement allows multiple investors to hold direct, undivided ownership in a single property. Each owner’s interest is recorded on the title and treated as real property, which means it qualifies for a 1031 exchange. TICs can offer flexibility for investors looking to pool resources into larger assets, such as office buildings, retail centers or industrial parks, while maintaining separate tax treatment.

However, TIC ownership can become complex in practice. Decisions about financing, property management and selling typically require unanimous consent among all owners. Because of this, TIC structures are often best suited for smaller groups of investors or short-term investment horizons.

Delaware Statutory Trusts (DSTs)

DSTs, on the other hand, are a popular modern alternative for investors seeking passive ownership. With a DST, multiple investors purchase fractional interests in a trust that owns one or more properties. The IRS recognizes DST interests as direct real estate ownership for 1031 purposes, meaning they qualify for tax deferral.

DSTs are professionally managed, eliminating the day-to-day burdens of property oversight, and are commonly used in larger institutional-grade real estate offerings. While investors don’t control operations, they benefit from diversification, steady income potential and continued 1031 eligibility in future exchanges.

Both TICs and DSTs offer compliant paths for reinvestment that preserve the benefits of a 1031 exchange without crossing into restricted partnership or LLC ownership structures. The best fit depends on your investment goals, desired level of control and liquidity needs.

Partner With Experts Who Understand Complex 1031 Structures

The National 1031 team has decades of experience helping investors structure secure, compliant exchanges involving even the most sophisticated ownership scenarios. We’ll help you evaluate your options, navigate the IRS requirements and execute a strategy that protects your gains and positions your portfolio for future growth.

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Contact us today to speak with an expert and move forward with confidence.

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