1031 Exchange Real Estate Drop & Swap

Tall skyscraper 1031 Exchange Properties

Taking advantage of a 1031 Exchange, while involving many steps, is usually straightforward enough for a single property owner. Things get more complicated if you’re involved in an LLC as an investor. The structure of this legal entity makes it harder for one party to leverage 1031 Exchange benefits when the other has other plans for the sale, such as simply cashing out.

One solution you can consider is called the drop and swap. In this practice, you essentially dissolve the LLC and turn the structure into a tenancy in common (TIC). How does this work? What are the major considerations that every investor must take into account? Realized 1031 has shared a comprehensive guide to help you understand the 1031 Exchange real estate drop & swap. Let’s dive in.

The Rules of a 1031 Exchange

To learn why a drop and swap is necessary for a 1031 Exchange when an LLC is involved, we must first understand how the latter works. A 1031 Exchange is the “like-kind” exchange outlined in section 1031 of the IRS revenue code. Thanks to this process, investors can indefinitely defer capital gains taxes as long as they swap a property for something that’s “like-kind.” In such an exchange, there was no sale. The investors won’t have to pay taxes until they eventually sell the acquired property.

The IRS has set many rules to ensure that 1031 Exchanges go unabused. The most well-known of these regulations is the 180-day rule, which requires the entire exchange to happen within 180 days.

In this article, we will focus on two other rules that play a role in LLCs. First is how the IRS recognizes partnership interest as non-exchangeable. As such, investors cannot swap these shares for other assets. The other rule is that a taxpayer who sold the relinquished property must be the same taxpayer that acquires the new one.

These rules create a dilemma for LLCs. The first rule eliminates any chance of a 1031 Exchange if one partner wants to cash out. The second rule requires the LLC to be the same entity that purchased the acquired property. Thanks to these two stipulations, individual investors cannot use their own shares to exchange for the asset they want. In this scenario, a drop and swap becomes a viable solution.

What Is a Drop & Swap? The Basics

A drop and swap is simply the practice of “dropping” the ownership structure of a property from an LLC to a co-ownership. In this sense, the partners become co-owners under a tenancy in common (TIC) structure. In this arrangement, each co-owner has undivided fractional interests while maintaining rights of ownership.

Thanks to this structure, the co-owners won’t have to sell partnership interests, which disqualifies them from a 1031 exchange. Instead, each co-owner can individually decide how to proceed with their share of the property. Some may choose to cash out, while others can defer taxes by engaging in a 1031 exchange — the “swap.”

Are Drop and Swaps Legal?

Yes. Drop and swaps are legal, and there’s no IRS stipulation stopping this practice. The only thing the IRS doesn’t allow is the exchange of partnership interests, which are considered personal assets. For fractional interests under a TIC, investors are free to do whatever they want.

Doing an exchange while a property is under an LLC is actually perfectly legal. As we mentioned, the taxpayer relinquishing the property must be the same as the one that acquires the like-kind property. At an entity level, the exchange is still possible since the LLC is the taxpayer. Problems only arise if one partner doesn’t want to take this route.

1031 Drop and Swap: An Example Scenario

To illustrate how a drop and swap process can happen, let’s create a theoretical scenario. John, Ed, and Dani are partners in an LLC that owns real estate property. All three want to sell the property for varying reasons, but they have disagreements on the next step with the proceeds.

In our example, John and Ed want to use the proceeds in a 1031 Exchange to defer the capital gains taxes. Dani, on the other hand, wants to cash out and use the funds for personal reasons. The situation can go in two ways.

The LLC sells the real estate property, and each partner gets their share of the proceeds. Since a sale happened, the proceeds are taxable. Dani got the cash she wanted, and so did John and Ed. However, the latter two had less money to invest in another property because of capital gains taxes.
John and Ed convince Dani to exchange the property through the LLC. After the 1031 Exchange, all the equity went into acquiring the property. John and Ed were able to defer taxes, but Dani wasn’t able to cash out.

In both scenarios, someone had to make a compromise and wasn’t able to meet their investment goals. A drop and swap can serve as a solution that lets everyone do what they want with their interest.

Once the three “drop” the LLC structure and use a TIC as individual co-owners, everyone receives a direct ownership interest. The value of each interest is equivalent to the relinquished membership interest from the LLC.

Another drop-and-swap scenario would be for Dani to join an LLC created by John and Ed. The new LLC and Dani can then create the TIC, after which Dani can transfer her membership interests and cash out. She will need to pay taxes, and John and Ed can transfer their proceeds to a qualified intermediary and begin the exchange process.

In most cases, maintaining the LLC between John and Ed is the preferred setup. That’s because dissolving an LLC completely before a 1031 Exchange can raise a red flag that invites IRS scrutiny. In the worst-case scenario, the agency will see this practice as a violation of the “holding requirement,” where a property must be held for investment and not resale.

The IRS might argue that the change in structure was simply a step towards liquidation rather than a continuation of an investment. As such, the agency might disqualify the exchange and leave you liable for capital gains taxes.

Common Challenges and Pitfalls in a Real Estate Drop and Swap

As we mentioned above, drop and swap can be prone to IRS scrutiny. Again, this practice is legal. However, improper timing can raise the proverbial eyebrow of the agency, giving them the impression that the drop and swap is a pretext for selling rather than a true like-kind exchange. As such, it’s important to put some distance between the drop and the exchange. This proactive step demonstrates your intention to hold the property for investment.

Another common challenge in a drop and swap is the complex documentation involved. Not only are you dissolving an LLC, but you’re also creating a TIC, which has its own set of legal processes. If you make errors in the documentation and structuring, you could face penalties or disqualification from the exchange, making you liable for tax payments.

Best Practices To Facilitate a Successful Drop and Swap

To lower the chances of the risks above, here are some of the best practices you can follow.

Work With Legal and Tax Professionals: Consulting with experts who specialize in 1031 Exchanges — like us at Realized 1031 — helps you navigate the complex requirements of a drop and swap.

Consider the Tax Implications: Dissolving an LLC can make an impact on each individual investor’s tax situation. Make sure you’re aware of how this step could affect yours to avoid any unseen challenges and liabilities.

Distance the Drop and the Exchange: This strategy shows your commitment to holding the property and makes you less likely to be the target of scrutiny from the IRS.

Maintain Good Communication With Other LLC Members: Dissolving an LLC is a major process. Having everyone on board during the planning and execution stage ensures that all members are aligned and reduces the likelihood of disputes or misunderstandings. Clear communication also helps ensure that all partners are fully aware of their responsibilities as well as the potential outcome of the drop and swap.

Wrapping Up: 1031 Real Estate Drop and Swap Basics

A drop and swap is a process that helps investors in LLCs take advantage of 1031 Exchanges. By dissolving the LLC and entering a TIC, these investors can turn their partnership interests into direct ownership interests, which are eligible for like-kind exchanges. The other co-owners can do as they please with their interests, such as cashing out.

If you’re considering a drop and swap, make sure that you understand the intricacies before committing to this strategy. Contact 1031 Exchange professionals like us to receive guidance and solutions.

The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.