Partnerships. Entities. Multiple properties.
Most investors are people of action, and taking action usually results in multiple investments, often across different entity structures. This can present a challenge when it’s time for a 1031 exchange.
More investors are looking to engage in 1031 exchanges this year, as activity has picked up 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 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 want to cash out while others want to proceed with the exchange, or when an investor wants 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 individual investors hold 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 funds can 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 for investors in PA. However, a recent court case decision on transfer tax involving an LLC with the same ownership may have set a precedent allowing investors to change entities without triggering transfer tax. Investors should check with their attorney before assigning interest in an LLC to confirm.
Steps to Execute a ‘Drop and Swap’
- Plan the timing. To minimize IRS scrutiny, the ownership entity should plan well in advance of a sale, converting partnership or LLC interests into direct (TIC) ownership as far ahead of the exchange as possible. Individual investors should also hold their TIC interests for a period before selling — there’s no exact timeframe required by law, but a holding period of at least several months, ideally a year or more, helps demonstrate investment intent.
- Deed transfer (the drop). The entity holding the property is dissolved, and ownership of the property changes to tenants in common (TIC).
- Property sale and exchange (the swap). When the property sells, investors wishing to do a 1031 exchange reinvest their proceeds into new properties, while those cashing out pay taxes on their gains.
- Replacement property acquisition. Investors continuing with the exchange complete their purchase of like-kind properties within the required 1031 exchange timelines — a 45-day identification period and a 180-day completion period.
Example: three partners own a property together in an LLC. Larry and Moe want to exchange this investment for another one through a tax-free 1031 exchange. Moe, however, has decided he wants his money from the sale to buy a boat, and no longer wants to be partners.
Larry, Moe, and Curly convert the ownership of the property from the LLC, where they each hold 33%, into tenants in common in their individual names (or individual LLCs) on the deed. When the property sells, Larry and Moe can do their 1031 exchange with their combined 66%, and Curly can take his cash, pay his taxes, and go buy the boat.
The ‘Swap and Then Drop’
Alternatively, you can ‘swap and then drop.’ This is the reverse approach, where a jointly owned LLC sells the property, completes a 1031 exchange, and closes on a replacement property. Later, individual owners of the LLC can 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 with dropping a partner out after purchasing a replacement property is the cash needed to pay that partner out. If the property was purchased in cash, a cash-out refinance after closing can provide the payout amount needed to drop a partner out.
Legal and IRS Considerations
The IRS closely scrutinizes ‘drop and swap’ transactions to prevent tax abuse. The main concern is whether investors truly ‘held’ their interest for investment purposes before swapping. If the IRS deems the exchange an attempt to circumvent tax rules, it could disqualify the transaction and trigger 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 lets investors who wish to continue with a 1031 exchange do so, while others can exit with minimized tax consequences.
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