Partnerships. Entities. Multiple properties.
Most investors are people of action, and taking action usually results in multiple investments, often in different entity structures. This can present a challenge when one is ready to do a 1031 exchange.
Many more investors are looking to engage in 1031 exchanges this year, as activity has been increasing and prices have remained stable.
However, when multiple investors hold interests in a property, and some want to cash out while others wish to continue deferring taxes, an approach known as the “drop and swap” can be used. This technique allows for a smooth transition where individual investors can either exit or continue participating in a tax-deferred exchange.
Understanding the “Drop and Swap” Strategy
The “drop and swap” strategy is commonly used in partnerships or limited liability companies (LLCs) that own investment properties. In a standard 1031 exchange, the entity that sells the relinquished property must be the same entity that acquires the replacement property. This presents challenges when some members of the ownership group wish to cash out while others want to proceed with the exchange. Or sometimes, an investor will want to sell multiple properties owned under different entities.
To navigate this, the entity can “drop” ownership by distributing real estate interests to individual members before the sale, converting their ownership from a partnership or LLC interest into direct tenant-in-common (TIC) ownership. Once the individual investors hold the title directly, they can then “swap” their respective portions through separate 1031 exchanges or sell their shares outright and pay any applicable taxes.
For individual investors who need multiple entities to match so the funds can all be pooled into a single exchange, they may assign their interest to the desired LLC ahead of the exchange.
Needing to pay transfer tax for an exchange of entities used to be a substantial deterrent to investors in PA. However, a recent court case decision on transfer tax in an LLC with the same ownership may have now set a precedent that investors can now change entities without worry of transfer tax. Investors should check with their attorney before assigning in an LLC to confirm.
Steps to Execute a “Drop and Swap”
Step 1: Planning the Timing
To minimize IRS scrutiny, the ownership entity should plan well in advance of a sale. This means converting partnership or LLC interests into direct ownership (TIC) as long as possible before the exchange.
- Holding Period – To avoid IRS challenges, individual investors should hold their TIC interests for a period before selling. Though no exact timeframe is required by law, a holding period of at least several months (ideally a year or more) helps demonstrate investment intent.
Step 2: Deed Transfer (The Drop)
The entity holding the property is dissolved, and the ownership of the property is changed to being Tenants in Common (TIC).
Step 3: Property Sale and/or Exchange (The Swap)
When the property sells, those investors wishing to do a 1031 exchange reinvest their proceeds with the same ownership into new properties, while those cashing out pay taxes on their gains.
Step 4: Replacement Property Acquisition
Investors continuing with the exchange complete their purchase of like-kind properties within the required 1031 exchange timelines (45-day identification period and 180-day completion period).
Example
Let’s say there are 3 partners that own a property together in an LLC. Larry and Moe want to exchange this investment for another one with a 1031 tax-free exchange. However, Curly feels hurt by his partners and decides he wants his money from the sale so he can buy a boat, and he no longer wants to be a partner.
Larry, Moe, and Curly convert the ownership of the property from the LLC that they each own 33% of to instead being Tenants in Common in their individual names (or Individual LLCs) on the deed. When the property is sold, Larry and Moe can do their 1031 exchange with their 66%, and Curly can take his cash, pay his taxes, and go buy the boat.
The Swap and Drop
Alternatively, you can ‘Swap and then Drop’. This would be a reversal of the above strategy, where a jointly owned LLC could sell the property, do a 1031 Exchange, and close on a replacement property. Later, owners of the LLC could be ‘dropped’ out after the exchange. As long as the legal entity stays in place owning the property, this strategy can work as well.
The complication in doing the ‘Drop’ after purchasing a replacement property may be the cash involved to be paid out to the partner dropping out. If the property was purchased in cash, a cash-out refinance after closing can provide the payout amount to drop out a partner.
Legal and IRS Considerations
The IRS closely scrutinizes “drop and swap” transactions to prevent tax abuse. The main concern is whether the investors truly “held” their interest for investment purposes before swapping. If the IRS deems the exchange as an attempt to circumvent tax rules, it could disqualify the transaction, leading to immediate tax liabilities. To reduce risk, seek guidance from tax advisors and legal professionals experienced in 1031 exchanges.
Conclusion
The “drop and swap” technique is an effective way for real estate investors to manage tax liabilities while allowing flexibility in ownership transitions. With proper planning and execution, this strategy ensures that investors who wish to continue with a 1031 exchange can do so, while others can exit with minimized tax consequences.
The investors we work with appreciate the balanced perspective we can provide, seeking opportunity while mitigating risk. Contact us today to discuss how we can help grow your wealth.
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