Fred and Bill Franklin were owners of a student housing property in the southeast. They operated the asset under an LLC set-up with a third member, a national REIT, which provided property management and operations services.
But after several years of hands-on ownership, Fred and Bill decided they’d had enough. While the property was successful, ownership required a great deal of effort. In fact, the brothers were interested in passive investments, possibly through exchanging the student housing asset into a Delaware Statutory Trust.
Unfortunately, the REIT member had other ideas. It wasn’t interested in buying out Fred and Bill’s partnership shares. It, too, wanted to sell the property, but rather than exchanging into a DST, it wanted to use sales proceeds from the property toward paying down a credit facility. “They didn’t want to buy the property from us,” Fred explained. “And it no longer made sense for us to be partners.”
The LLC’s usefulness had come to an end, and something needed to be done so all members could reach their investment goals. That “something” was the drop and swap.
What It Is
Through a drop and swap, members of a partnership, corporation, or LLC take legal steps to “drop” themselves from entities. The result is a tenant-in-common structure, allowing for fractional ownership of a real estate asset. Once the TIC is in place, the property is transferred to the owners as a separate interest; the owners can then make their own choices about what to do with their share.
Drop and swap can be effective, due to the following reasons.
- Under IRC Section 1031, partnership interests are not directly exchangeable into real estate. They are, in fact, considered personal property, and not like-kind to the acquisition or disposition of real estate.
- If a partnership or LLC wants to conduct a 1031 exchange, the entity must also buy the replacement property. Because of the entity setup, individuals within these structures are not allowed to “split” the property.
While the drop and swap can be a great way to unravel a partnership, LLC, or corporation, it’s important to keep the following in mind.
Allow plenty of time for the process. While the IRS doesn’t have any predetermined timelines for a drop and swap, it’s a good idea to begin the process as far out as possible. Dissolving an entity right before an exchange could be a red flag, and could possibly invalidate it.
Keep an eye on operations. A TIC set-up will have different property ownership and maintenance requirements than requirements set out in an LLC or partnership. For instance, TIC owners may find themselves responsible for property expenses.
Negotiate separately. When it comes to selling and/or exchanging the fractional shares, each TIC owner should do so independently. Nothing indicates “partnership” or “LLC” to the IRS more than separate owners that band together to negotiate as a single entity. This could nullify the requirements of a like-kind exchange.
When Arrangements Must End
Very few things last forever. This can be the case with LLC or partnership real estate ownership arrangements. Drop and swap allows for a legal unraveling so partners or members of an LLC or corporation can go their separate ways to pursue specific investment plans.
“It’s a good exit strategy,” Fred said. “Sometimes it’s a great remedy for a situation in which you and your partners have different investment goals.”