Your §1031 Tax-Deferral Options Were Just Significantly Improved by the NYS Tax Tribunal — How You Can Take Advantage for your Portfolio’s Growth.

A New York Administrative Law Judge ruled in favor of the taxpayer in a “Drop-and-Swap” case where the formal drop occurred substantially simultaneously with the closing.

In a notable win for real estate investors, the New York State Division of Tax Appeals ruled in favor of Benjamin Hadar, Rachel Hadar, and Ruth Shomron, affirming their eligibility for tax deferral under IRC §1031 following the sale of a Central Park West apartment building in 2016.

So, what does this mean for real estate investors interested in completing a §1031 “like-kind” exchange of their own?

1. The fundamentals of a standard delayed 1031 like-kind exchange:

First, let’s review the fundamentals. A delayed §1031 like-kind exchange is a tax-deferral strategy under §1031 of the Internal Revenue Code (IRC) that allows real estate investors to defer capital gains taxes on the sale of an investment or business property by reinvesting the proceeds into a like-kind replacement property.

In a standard delayed exchange, the investor sells the relinquished property first and then purchases the replacement property later. The key steps include:

1. Sale of Relinquished Property: The investor enters into a sale agreement and closes on the sale of the investment property.
2. Use of a Qualified Intermediary (QI): To comply with IRS rules, the proceeds from the sale are held by a QI. The proceeds never go directly to the investor.
3. Identification Period: Within 45 days of the sale, the investor must identify, in writing, potential replacement properties. The potential replacement properties must be of equal or greater value than the relinquished property.
4. Exchange Period: The investor must close on one or more of the identified replacement properties within 180 days of the sale of the original investment property (or the due date of the tax return, if earlier).
5. Completion: If all rules are followed, the investor can defer capital gains taxes on the sale of the original investment property.

This structure is commonly used to preserve capital, leverage investments, and grow portfolios tax-deferred.

2. The Dilemma:

A limitation of this tax-deferral strategy is that the investor partnership must maintain the same tax status (i.e., remain the same). Under IRC §1031 as long as the partnership meets the requirements that apply to all exchange transactions – the same taxpayer starts and completes the exchange, the replacement property is at least of equal value and both the relinquished property and replacement property will be held for investment or business purposes, etc. – then the “like-kind” exchange will be granted. This means that all of the members of the entity that sold the relinquished property must remain in the purchase of the replacement property (regardless of whether those interests are general or limited partnership interests) in order to defer the capital gains taxes on the sale of investment property.

If one of the investors in the partnership decides they want to withdraw from future investments and separate from the entity after the sale of the relinquished property, but before the purchase of a replacement property, then the partnership’s tax-deferral abilities are affected.

3. Typical Strategies to Circumvent Partnership Issues:

There has been a long-held belief that the following strategies might survive an audit while preserving the §1031 compliance, but these techniques are complex, involve IRS scrutiny and should be carefully structured and reviewed with a qualified tax attorney or CPA before implementing:

1. The Buyout Method:
2. (Before the exchange) The partners who want to proceed with the exchange contribute additional equity, which is used to buy out the retiring partner(s). The partnership, now with fewer partners, then enters into a §1031 exchange.
3. (After the exchange) The partnership completes the exchange and later buys out the retiring partner(s).
4. The Partnership Division: The partnership can split into two or more entities. If one of these new partnerships is composed of partners who owned more than fifty percent (50%) of the original partnership, then it’s treated as a continuing partnership. Only the new partnership with the largest fair market value continues the original tax attributes. This method is useful if one partner wants to do an exchange and another wants to cash out without doing a different exchange of their own.
5. Multiple Exchanges with Different Allocations: The method is used when both partners want to exchange but into separate properties. The partnership buys both properties and amends the operating agreement to allocate income and depreciation disproportionately (i.e., Abe gets 90% of Parcel A, while Bob gets 90% of Parcel B). They then subsequently dissolve the partnership and distribute the properties accordingly. This strategy requires careful planning and no pre-arranged agreement to dissolve.
6. The New Ruling by the New York State Division of Tax Appeals:

The petitioners, who were partners in a real estate entity called Upwest Co., LLC, executed a “Drop-and-Swap” transaction, which is a legal strategy in which a partnership distributes the real property ownership to its members, as tenants-in-common, by a separate conveyance transaction before the sale of the investment property, so that members may individually conduct §1031 like-kind exchanges, or opt to pay the capital gains on their ownership interest in the relinquished property.

The New York State Department of Taxation had initially rejected the like-kind exchange treatment, arguing that Upwest, not the individuals, was the true seller, and assessed millions in additional personal income taxes, interest, and penalties for 2016 and 2017.

However, the Tax Appeals Tribunal found that the petitioners had properly structured the transaction:

• They distributed the property from the partnership to the members as tenants-in-common before the sale;
• Each taxpayer acted individually and pursued separate §1031 exchanges into new investment properties;
• The court noted that their intent to exchange for like-kind property was well-documented and planned well before any sale contract was signed.

The Tribunal concluded that both of Upwest’s members, Hadar and Shomron, continued their investment in real estate through qualifying replacement properties, and thus, qualified for non-recognition of gain under IRC §1031.

Additionally, the Tribunal abated the penalties for substantial understatement of tax, further solidifying this as a victory for the petitioners.

4. Future Planning:

In summary, this ruling, dated June 12, 2025, opens the door for “Drop-and-Swap” transactions in New York as a viable option for continuing §1031 exchanges (even where the formal “drop” occurs substantially simultaneously with the closing), whenever investment partners elect to go their separate ways upon the sale of a qualifying investment property.

Looking to learn more about buying and selling investment property pursuant to a §1031 capital gains tax-deferred exchange, or to learn how to protect your §1031 exchange status? Email me at jcicero@dlpartnerslaw.com or call me at 212-624-4191.