“I’d love to take advantage of the benefits of a 1031 exchange but my partners want to cash out, is there anything I can do?”
This is one of the most common questions we receive. The short answer to this question, is yes; however it’s essential that it’s done correctly. First, let’s review two key IRS requirements.
Though not explicitly stated in Section 1031 of the tax code, in order for the transaction to be considered like kind, the same taxpayer who disposes of the relinquished property must be the same taxpayer who replaces the property. This can also be considered through the lens of whomever is on title to the relinquished property must be on also be on title to the replacement property. Additionally, as stated in IRC§ 1031(a)(2)(D), partnerships’ interests are not exchangeable. Therefore the partnership interest must be transitioned to a tenant in common interest prior to engaging in a 1031 exchange.
This can get complicated in the case that an individual is part of an LLC, partnership or trust and the other members of said group would prefer to receive their portion of the net sales proceeds, pay the taxes and “cash out” while one or more individuals want to defer their capital gains and depreciation recapture through a 1031 exchange. The most common technique to utilize if this is the case is referred to as a “Drop and Swap” transaction. This method changes the property title from a multi-party partnership or LLC to reflect individual names. Essentially, the taxpayer “drops” out of the LLC or partnership into a tenant in common relationship with their partners and then “swaps” into a replacement property. Let’s use the following example in order to break down the sequence of how to utilize the “Drop and Swap” technique.
Alpha Bravo, LLC is made up of four members that own a pro rata share of a commercial building. AB, LLC is considering selling the property for $1,000,000 in the next year, however three of the four members would like to pay the taxes and utilize the net sales proceeds of the sale for non-investment purposes, while the fourth member would like to utilize their portion towards another investment property utilizing a 1031 exchange.
In this illustration, one element that is key is the timing. Though it is possible to execute a “Drop and Swap” right before executing a 1031 exchange, it greatly increases the risk of an IRS audit. In regards to timing, the earlier the decision is made the better. In 2008, Form 1065 was amended to specifically ask if partnerships distributed undivided interest in partnership property to partners. This was done in part to track and identify the use of “Drop and Swap” and review the timing with more scrutiny. Our recommendation is to convert to tenants in common at least a year in advance of the closing of the replacement property, if possible.
In the case of Alpha Bravo, LLC, once they have made the transition from LLC to tenants in common and allowed time before the property is sold, the next step would be to file a Section 761(a) election. This notifies the IRS that you and the other tenants in common do not want to be taxed as a partnership. In addition to this, periodic payment of operating expenses is also advised in order to establish a fact pattern that you are tenants in common and not a partnership any longer.
As Alpha Bravo, LLC puts their commercial building on the market and eventually sells, another best practice is to negotiate and engage the sale agreement as individuals. Once the property is under contract, the lone individual who would like to pursue a 1031 exchange is free to do so with their percentage interest of the net sales proceeds of their sale.
As you can see, this can be a precarious process and it is one that you will want the input of your CPA and or Real Estate attorney. A “Drop and Swap” 1031 exchange can be utilized but must be done at the risk of the taxpayer. The earlier you begin considering this as an option the better.
Download a 10 point 1031 exchange checklist by clicking here. If you have a comment, we would enjoy hearing from you. If you have any questions, feel free to reach out to us via the options on the top right of this page, call our office at 800-227-1031 or contact us via email here
