Understanding the Drop and Swap in the Context of a 1031 Exchange

Understanding the Drop and Swap in the Context of a 1031 Exchange

Real estate investment partnerships, often formed as limited liability companies, general partnerships or limited partnerships, are a great way for groups of investors to pool resources and invest in real estate.  However, over time the investing goals of these partners may diverge.  Some of its partners may want to continue as is, others may want to cash out, while others may want to complete a 1031 exchange into a new property.

When it comes to a 1031 exchange, it’s important to note that a partnership interest isn’t considered real property under Internal Revenue Code 1031. Instead, it’s only the actual property held by the partnership that can qualify for tax-deferred treatment. The drop and swap technique might be a viable solution in such cases.

Drop and Swap Solution

The What

The Drop and Swap technique is used in situations where a property is owned by a partnership or group of investors, and not all members wish to participate in a 1031 exchange. This scenario can be challenging because the 1031 exchange rules require that the same taxpayer selling the relinquished property must acquire the new property. The Drop and Swap approach addresses this dilemma.

A typical solution to this issue involves the partners ending their partnership before selling. They then equally divide the property ownership among themselves based on tenant in common (“TIC”) rights (this is known as the “drop”). After that, each individual owner transfers their portion of the property to the buyer. Some previous partners then trade their shares for a new property (referred to as the “swap”), while the rest cash out and settle any taxes due on their profit.

The How

The partnership “drops” the property into a Tenants in Common (TIC) agreement. This action splits the property into separate shares for each partner, effectively making each partner an individual owner of a portion of the property.   Each partner now holds a direct interest in real estate, rather than an interest in the partnership. This step is crucial because it aligns with the 1031 requirement that the same taxpayer selling must be the one buying.

After the drop, the partners are free to choose their own paths.  Those wishing to defer taxes via a 1031 exchange can use their portion of the proceeds to invest in a new property.  Partners not interested in continuing with the 1031 exchange can sell their shares and pay the applicable taxes.

Risks

While the drop and swap tactic is widely used, it carries tax-related uncertainties. To be eligible for 1031 exchange benefits, both the sold and acquired properties must be held for investment and meet the qualified use criteria if the relinquished property is swiftly transferred to individual partners from the partnership just before its sale, the IRS might argue that the partners didn’t acquire the property with investment intentions but solely to sell it. This holds true even if the partnership had been the long-term owner of the property prior to the drop and swap the IRS has not published any rulings that give investors certainty about the ability to defer tax in an exchange if the taxpayer uses a drop and swap structure.  There isn’t a precise minimum holding period defined in the tax code, however 24 months is often considered a reasonable period.  The time periods are critical as

The IRS pays close attention to drop and swap transactions, especially when the partnership appears to continue in practice. For the IRS to respect the transaction, the entity into which the partner “drops” their interest must be recognized as a separate and distinct entity from the original partnership. If the IRS deems that the partnership still exists in practice, it may argue that the partner never truly held a TIC interest in the property and disallow the 1031 exchange, resulting in significant tax consequences.

As discussed above, if the drop and swap occur shortly before the sale of the property, it raises red flags for the IRS. A short holding period suggests a lack of genuine business purpose behind the transaction, making it appear as a mere tax avoidance scheme.

Additionally, If the partners continue to operate the property jointly, as they did before the drop and swap, it suggests that the partnership still exists in practice. The IRS looks for changes in the management and operation of the property to confirm that the partnership has truly dissolved.    The absence of separate accounting, intermingling of funds between former partners, use of partnership name and continued identically management of the property are all indicators that the partnership may still be operating in practice,

Certain states, such as California often can be more rigorous in reviewing such transactions and often apply stricter standards.

Mitigating Risks

To mitigate the risks and ensure that a drop and swap transaction is respected by the IRS, it is crucial to plan in advance: Engage in drop and swap transactions well before any potential sale of the property, establishing a clear timeline that demonstrates a genuine business purpose. Ensure that the new entity operates independently of the original partnership, with separate accounting and management.  Legally dissolve the entity in any state that it is registered and file final partnership tax returns.

Make certain to be up to date on all recent rulings and guidance.  Consult with tax professionals and legal advisors who specialize in partnership structures and 1031 exchanges to navigate the complexities of the transaction and ensure compliance with tax laws.

Conclusion

The Drop and Swap is a sophisticated strategy within the realm of 1031 exchanges. While it offers a solution for partnerships with differing goals, it comes with a set of challenges and requires careful planning and professional guidance. As with any investment strategy, understanding the implications, legalities, and tax consequences is crucial for success.

Navigate the Drop and Swap in 1031 Exchanges

Understanding your options in a 1031 exchange is crucial. Whether you’re considering a drop and swap or navigating partnership challenges, get the insights you need. Maximize your investment strategy with expert guidance from Voss Real Advisors.

Voss Real Estate Advisors

May 6, 2024

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