The most common type of tax-deferred exchange undertaken by partners seeking to exchange out of partnerships is commonly referred to as the “drop and swap” exchange. In such an exchange, a partnership owning real property about to be sold distributes undivided fractional interests (“UFIs”) in that property to its partners. The partners then sell the UFIs, and those partners who wish to effect tax-deferred exchanges acquire replacement properties.
Conceptually, the IRS should have no objection to a “drop and swap” exchange since distributions of property from partnerships generally are not taxable events. However, the IRS long has contested not only “drop and swap” exchanges, but other types of exchanges involving partners and partnerships.
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