1031 Exchange Drop and Swap: Risk vs Reward

by Maura Snabes, Esq., CES, NTP

July 2024                                                                                                               

We all know that taxpayers have been doing “drop and swaps” for many years, some with pre-planning and more often, with no preplanning. The question becomes: Is this method worth the risk of having the IRS disqualify the exchange upon audit? Or, is the risk minimal enough to reap the benefits of the tax deferral?

The situation arises where title is in an entity, but there is no mutual agreement among the members/partners to cash out upon closing and pay the tax or, to effectuate a 1031 exchange upon sale closing and acquire a new property in the entity name. A drop and swap allows the partners/members to "drop" ownership from an entity to co-ownership (tenants in common), enabling partners/members to individually decide whether to cash out their interest at closing and pay the gain or reinvest and defer taxes through a 1031 Exchange.

Sounds great--why is this a problem? A few reasons: 1) Partnership interests are not exchangeable; 2) The same taxpayer that sells the Relinquished Property must acquire the Replacement Property; and 3) A taxpayer should have held the Relinquished Property for productive use in a trade or business or for investment for some period of time prior to the exchange. If there is a title transfer immediately prior to closing, the IRS may determine that title was acquired by the individual for the sole purpose of selling it.

Process:

There are various methods used to accomplish the drop and swap, with the methods below being the most common and least complex. A taxpayer should always ask their tax and legal professional for advice when structuring a drop and swap:

• Entity conveys title to all partners/members prior to closing as tenants in common (TIC). This is usually a liquidating distribution and generally tax-free under IRC Section 731. Each partner decides if they want to cash out in the sale or do a 1031 exchange with their TIC interest.
• Entity conveys title to only the members that want to effectuate a 1031 exchange. Those parties will now hold as tenants in common with the entity. Entity will cash out at closing and individuals will effectuate a 1031 exchange on their TIC interest.
• Entity will be the taxpayer for the exchange. After acquiring the Replacement Properties that each partner/member wants to ultimately own, it will convey title to each individual partner/member accordingly. This is a swap and drop.
• The transaction is complex with various tax implications depending on the structure chosen. In addition, there be additional internal structuring of the entity involved as well.

Risks:

• Property must be held for investment to qualify for 1031 treatment.
• Immediate drop and swap before sale may result in disqualification by the IRS.
• Partnerships must answer Schedule B questions on form 1065 about drop and swap transactions, which may increase audit risk.
• Secured lender on property may not allow conveyance to individual partners/members.
• IRS has not published any rulings on entity drop and swaps that give investors certainty regarding using the drop and swap structure. Courts have been more favorable.

Practical Tips:

• Drop out of the entity before closing the relinquished property. The time period for this conveyance to the individuals will be determined by your tax or legal advisor. There may be other legal implications with the conveyance (i.e. liability, accounts receivable, action as a partnership, etc….)
• Maintain records to establish intent for business or investment purposes.
• Follow criteria in Rev. Proc. 2002-22 for TIC interests.
• Examine relevant recent case law and Revenue Procedure 2002-22.
• Negotiate, enter into the purchase agreement and sell the relinquished property as an individual.
• Do not drop from an S corporation-this will be a taxable event
• Dropping from a Trust or Estate has more favorable rulings than from an entity.

Bottom Line: The drop and swap or swap and drop exchange is a great tool for investors to have in their toolbelt for deferring capital gains taxes when an entity’s members/partners are not in agreement with the disposition of funds upon sale of its real estate. But, be sure to consult with a tax and/or legal professional well in advance to determine the best steps to protect the validity of the exchange.