Can You Defer Taxes When One Owner Cashes Out?

A 1031 exchange is one of the most powerful tools available to real estate investors looking to defer capital gains taxes while continuing to grow their portfolio. But things can get complicated when multiple owners are involved, especially if one of them wants to cash out while others want to proceed with the exchange.

So, can you still defer taxes when one owner cashes out? The short answer is: how the transaction is structured matters. Let’s break it down in a practical, easy-to-understand way.

Understanding the Basics of a 1031 Exchange

Before diving into multi-owner scenarios, it’s important to understand what a 1031 exchange is.

Under Section 1031 of the Internal Revenue Code, investors can defer paying capital gains taxes when they sell a business or investment property and reinvest the proceeds into another business or investment property. The goal is to keep your money working for you rather than losing a portion to taxes.

However, strict rules apply:

The property must be held for investment or business purposes
Replacement property must be of equal or greater value
Timelines (45-day identification and 180-day closing) must be followed

The Challenge with Multiple Owners

When a property is owned by multiple individuals such as partners, family members, or LLC members, each owner may have different financial goals.

For example:

One owner may want to cash out and take profits
Another may want to continue investing and defer taxes

This creates a challenge because a 1031 exchange typically requires all proceeds to be reinvested to fully defer taxes.

If one owner takes cash (also called “boot”), that portion becomes taxable.

Scenario 1: Straight Split at Sale

If the property is sold and proceeds are distributed among owners at closing, the outcome is straightforward:

The owner who takes cash must pay capital gains tax
The remaining owners can still perform a 1031 exchange but only on their share

However, this structure must be handled carefully. If the property is owned under a single entity (like an LLC), the IRS will treat the entity not the individuals as the taxpayer.

This means:

The entire entity must exchange, or
The distribution could trigger taxable events for everyone

Scenario 2: “Drop and Swap” Strategy

One common workaround is the “drop and swap” strategy.

Here’s how it works:

The ownership entity (e.g., LLC) is dissolved prior to sale
Individual owners receive direct ownership (tenancy-in-common interests)
Each owner then decides independently:
- Exchange their share, or
- Cash out and pay taxes

While this approach offers flexibility, it comes with risk. The IRS may challenge the transaction if it appears the property was not held long enough in individual names for investment purposes. And some states, like California, have advised that they will audit drop-and-swap transactions.

Key consideration: Timing matters. The longer the ownership is held after the “drop,” the stronger the position.

Scenario 3: “Swap and Drop” Strategy

Another approach is the “swap and drop.”

In this case:

The entity completes the 1031 exchange first
After acquiring multiple replacement properties, ownership interests are distributed

This method is sometimes viewed as less risky than “drop and swap,” but it still requires careful planning to ensure compliance with IRS intent rules.

Scenario 4: Partnership Buyout Before Exchange

A cleaner option in many cases is a buyout before the exchange.

One owner buys out the exiting partner’s share
The remaining owner(s) proceed with the 1031 exchange

Benefits:

Simplifies the exchange process
Reduces IRS scrutiny
Keeps ownership structure intact

The downside? It requires sufficient liquidity or financing to complete the buyout.

Important Tax Considerations

When one owner cashes out, here are key points to keep in mind:

Boot is taxable: Any cash received is subject to capital gains tax
Entity structure matters: Partnerships and LLCs are treated differently than individual ownership
Intent is critical: The IRS evaluates whether the property was held for investment
Documentation is key: Proper legal and tax guidance is essential

Trying to “wing it” in a multi-owner 1031 exchange can lead to costly mistakes.

Best Practices for Multi-Owner 1031 Exchanges

If you’re facing a situation where one owner wants out, consider these best practices:

Plan early: Ideally before listing the property
Consult professionals: Tax advisors, attorneys, and qualified intermediaries
Evaluate ownership structure: This determines your flexibility
Avoid last-minute restructuring: It increases IRS scrutiny
Document intent clearly: Especially when using TIC structures

The earlier you address ownership differences, the more options you’ll have.

Final Thoughts

Yes, it is possible to defer taxes in a 1031 exchange even when one owner cashes out but it requires careful structuring and strategic planning.

There is no one-size-fits-all solution. Whether you use a drop and swap, swap and drop, or a buyout strategy depends on your ownership structure, timing, and long-term investment goals.

Handled correctly, a 1031 exchange can still provide significant tax advantages—even in complex multi-owner scenarios.

Ready to Navigate Your 1031 Exchange with Confidence?

If you’re dealing with a multi-owner property or considering a 1031 exchange, expert guidance can make all the difference. Contact Four Springs Capital Markets, LLC to explore tailored solutions and get professional support to structure your exchange the right way, while maximizing tax deferral and minimizing risk.