The Tax Advantages of a Synthetic Drop and Swap

Co-Authored By: Steve Wilson is a senior counsel in the Real Estate Practice Group in Haynes Boone’s San Francisco office.

For real estate investors who want to leave a partnership, converting the partnership to a Delaware Statutory Trust (DST) can allow the investors to go their separate ways while retaining the tax benefits of a Section 1031 like-kind exchange. Converting a partnership or an LLC to a DST is often known as a “synthetic drop and swap.”

The effective use of this strategy assumes either:

The DST structure gives the investors the flexibility sell or retain their interests.

A DST can offer a practical alternative to a drop and swap, a popular tax planning strategy often chosen when members of a business partnership want to sell appreciated assets. Under a drop and swap, the partnership effectively redeems partnership interests by distributing tenant-in-common (TIC) interests in its assets to the partners. This allows each TIC owner to decide whether to cash out or reinvest the interests in new assets.

However, a big limitation of the drop-and-swap is that it only works if it is planned in advance. Once a partnership has shown clear intent to sell property, adopting this strategy retrospectively is more likely to face challenges from the IRS.

Post-sale-agreement attempts to implement a drop-and-swap can face IRS questions, citing doctrines like assignment of income or step transactions. The IRS might also argue that TIC ownership doesn’t meet Section 1031’s “held for investment” requirement.

While there is no guarantee the IRS wouldn’t make similar arguments in these cases, however, a DST conversion can achieve similar tax benefits as a drop-and-swap.

Careful planning well in advance of the decision to sell is the single factor most likely to protect the intended tax treatment of the transaction. This includes drafting the documentation that will become effective when the original entity is converted to a Delaware DST.

A DST is a legal entity created under Delaware law that provides liability protection similar to LLCs or partnerships. A DST can be set up as a multi-beneficiary grantor trust under federal tax rules. Essentially, each grantor-beneficiary owns a share of the DST’s assets proportional to their interest in the trust. For example, if someone holds a 10% interest in a DST that owns investment property, they’re treated as owning 10% of that property for tax purposes.

In 2004, the IRS issued guidance (Rev. Proc. 2004-86) confirming that DST interests could qualify as replacement property for Section 1031 exchanges. This ruling spurred the popularity of syndicated DST investments in the Section 1031 market, gradually overshadowing TIC investments. DSTs can also help individual taxpayers manage tax consequences when other strategies, like drop-and-swaps, are unavailable.

Within the last 10 years, there was a bubble in DST transactions, mostly de novo creations of DSTs to hold newly acquired property and harvest up-leg exchange proceeds.  Paralleling the history of the private placement industry in the 1980s, some of these failed spectacularly due to such things as dishonest conduct and incompetent property management. 

The primary investor risk in failed DST investments is the fact that if a property is foreclosed or a “gain recognition event” occurs, the investor’s reportable taxable gain will be his percentage share of the difference between the debt cancelled (“forgiven”) in the transaction and his adjusted basis in his DST units, which basis may be quite low.

Recently created DSTs are typically the creation of Wall Street houses and conservatively structured, but also have modest investor returns and high fee schedules.

Here’s how it works: The partnership converts into a DST under state law before the property sale is finalized. This triggers the partnership’s liquidation for federal tax purposes, with each partner receiving an undivided interest in the partnership’s assets and liabilities based on their ownership share.

Under the Delaware conversion statute, the assets, liabilities and contracts of the partnership become the assets, liabilities and contracts of the DST. Delaware’s conversion statute expressly directs that the conversion shall not be construed as a transfer of assets or liabilities from the partnership to the DST, operating in a manner akin to a corporate merger statute. The DST is regarded as a continuation of the partnership for state law purposes.

If structured correctly, the DST will qualify as an investment trust, and each partner becomes a grantor-beneficiary. The DST can then sell the property, and each beneficiary can decide how to reinvest their share of the proceeds.

Because the conversion happens without formally transferring the partnership’s assets—thanks to Delaware law—the DST remains the same taxpayer that signed the purchase and sale agreement. This approach helps avoid violating the Section 1031 same taxpayer rule, similar to how corporate mid-exchange mergers are handled.

The structuring approach we describe employs (for California and states with similar conversion laws) the authority in the California Corporations Code at Chapter 11.5, Sections 1150 through 1159, which authorize the statutory conversion of a CA LLC or LP into “another foreign entity.”  The Delaware conversion law anticipates that the existing jurisdictional state has such authorizing legislation, so the two sets of laws fit together neatly.

For estate planning, DSTs offer step-up in basis for beneficiaries, and can be more easily divided among heirs than real estate that is owned directly.

Investors planning a DST conversion need to be aware of “Seven Deadly Sins,” a reference to seven IRS-imposed restrictions outlined in Revenue Ruling 2004-86. These rules are designed to ensure DSTs qualify for 1031 exchange treatment by maintaining their passive investment nature.

Here’s a breakdown of each “sin”:

Once a DST offering is closed, no new equity can be added—neither by current nor new investors. This prevents dilution of ownership and maintains the trust’s original structure.

DST trustees cannot borrow new funds or renegotiate existing loans unless there’s a loan default due to tenant bankruptcy or insolvency. This ensures financial stability and predictability.

Proceeds from the sale of DST property must be distributed to investors. The trust cannot reinvest these funds, preserving the passive nature of the investment.

Trustees may only spend on routine maintenance, minor non-structural improvements, or legally required upgrades. Major renovations are prohibited.

Any cash reserves must be invested in short-term, highly liquid instruments. This ensures funds are readily available and not tied up in long-term investments.

All excess cash (except necessary reserves) must be distributed to investors regularly, reinforcing the passive income model.

Trustees cannot enter new leases or renegotiate existing ones, unless a tenant is bankrupt or insolvent. This maintains lease stability and avoids active management.

These restrictions are essential for DSTs to maintain their eligibility for 1031 exchanges. While they help preserve tax advantages and passive ownership, they also limit flexibility. Investors should weigh these carefully when considering DSTs.

Investors also need to understand several practical considerations:

While the flexibility and tax advantages of a synthetic drop and swap can be compelling, investors need to consider the potential risks and roadblocks.

For instance, DST investments are generally illiquid, with no active secondary market for selling interests. This means investors may be unable to exit the investment easily if their goals or needs change.

Similarly, DST investors have limited control over the investment and property management decisions, as they rely on the DST sponsor or trustee. This passive nature may not suit investors who prefer active involvement.

As with any complex real estate strategy, it’s important for investors to understand the potential advantages and risks, and to conduct thorough due diligence before investing in a DST. Consulting with financial and tax advisors is recommended to understand how the potential benefits and implications for an individual’s specific goals and circumstances.

Contact us to learn more about the synthetic drop and swap, and other tax planning services.