Much has been written about “drop-and-swap” transactions, whereby a real estate partnership distributes to a partner(s) a tenant-in-common interest (“TIC”) in real estate, and the partner then sells the TIC interest and engages in a §1031 like-kind exchange. Questions that have been raised when addressing whether there is a valid §1031 exchange include (1) how long does the distributee have to hold the distributed property before sale, (2) what benefits and burdens of ownership does the TIC holder have to assume, and (3) to what extent are the details of the sale transaction documents relevant. In fact, some tax professionals believe that the IRS may have an interest in looking at the validity of a drop-and-swap transaction by reason of question 12 on Schedule B of Form 1065, which provides: “At any time during the tax year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property?” However, there is no reported case of the IRS pursuing a challenge to a drop-and-swap transaction in over three decades.

Nevertheless, there are current state proceedings in this arena. On June 12, 2025 (and just reported in advance sheets last week), an Administrative Law Judge (“ALJ”) issued her decision in the New York Division of Tax Appeals hearing of In the Matter of the Petition of Hadar and In the Matter of the Petition of Shomron (Determination DTA Nos. 850122 and 850123) finding that a distribution of a TIC interest followed on the same day by separate swaps by two of the three TIC owners (the only partners of the partnership) of the TIC interests satisfied the requirements of §1031. Given that New York follows federal law for the validity of a like-kind exchange, federal law became relevant to the determination of whether the two petitioners engaged in a valid §1031 exchange. Perhaps of importance in the victory of the petitioners in the matter was, (1) the deeds transferring the property to the three TIC owners were recorded and the TIC owners were identified in the sale documents as the transferors of the property to the purchaser, (2) the TIC owners entered into a TIC agreement, (3) virtually all the documents (with the “mistaken” identification of the partnership as the seller on the final settlement statement as the noted minor exception) referred to the TIC owners as the sellers, (4) the property’s lender was aware of and did not object to the distribution of TIC interests, and (5) the sale proceeds were deposited with separate QIs in the names of the respective TIC owners. Of course, the TIC owners did not report any rental income or property expenses, because the sale took place on the same day as the TIC distribution, but the ALJ did not find this fact to be significant.

Interestingly, one of the New York revenue agents involved in the audit testified that for a TIC owner to engage in a successful §1031 exchange, the distributed property must be held for a “[m]inimum of a couple of months” (likely to meet the §1031 requirements that both the relinquished and replacement properties be held for investment or for use in a trade or business, often referred to as the “held for” replacement). Perhaps the most significant statement made by the ALJ was that “[w]hile petitioners held title to the [distributed property] only momentarily, the plain language of IRC (26 USC) § 1031 does not require ownership of the relinquished property for any particular period of time.” The ALJ cited several cases where a taxpayer only held the relinquished property or the replacement property for a moment in time and the holding was that there was a valid §1031 exchange, with the ALJ essentially ruling that the “held for” requirement of §1031 “tacked.” The ALJ also ably distinguished Chase v. Commissioner, 92 TC 874 (1989), which was a rare taxpayer loss in this arena, by comparing all the “document failures” in Chase with how the documents in the case of the petitioners precisely followed the form of their §1031 transaction. Of note, however, is that there was no discussion in the matter of the step-transaction doctrine, most notably contained in Court Holding.

Unfortunately, the Hadar/Shomron determination is a New York tax matter and has no precedential effect for federal tax purposes, if the IRS were to contest a drop-and-swap transaction. However, the precise documentation entered into by the petitioners is a good roadmap for how to do things right, although most tax professionals are far more comfortable when there is some separation in time between the TIC distribution and the sale of the distributed property.

Code §1031developments are always a topic ripe for discussion at our Tax Planning Forum programs, and our Fundamentals of Flow-Through programs where we discuss “safer” approaches to a drop-and-swap transaction. Registration is open for both programs, and do not miss the Early-Bird discount tax that ends on July 31st.