Basics of the “Drop and Swap”

At 1031 Exchange Place, one of the most common questions we get as we provide comprehensive 1031 exchange services is this: I want exchange benefits, but my business partners want to cash out – what can I do? Can I do a 1031 exchange in a partnership?

In short, the answer is often ‘yes’ – using a procedure called the “Drop and Swap.” However, there are some important requirements that need to be understood.

Two Vital Requirements

  • It’s not directly stated in section 1031 of the tax code, but there’s a general rule that in order for these exchange transactions to count as ‘like kind’, the same person who sells the property is required to be the one who replaces it as well. Down similar lines, whoever holds the title for the relinquished property must be on the title for the new one.
  • In addition, per IRS Section 1031(a)(2)(D), interests in partnerships are not exchangeable – as such, the interest has to be transitioned to a tenant in common interest before a 1031 exchange can take place.

When It Gets Complicated

This is simple enough in some cases, but in others, it can get a bit complex. If you’re part of an LLC, partnership or trust where other members are looking to cash out but you or other parties in the arrangement want to use a 1031 exchange to defer capital gains, the most common technique here is the “Drop and Swap.”

During a Drop and Swap transaction, you’re basically “dropping” yourself from your partnership – instead, it becomes a tenant in common relationship with your partners. From there, you then “swap” into a replacement property. In essence, the Drop and Swap changes the property title in this partnership, removing individual names to achieve the transfer.

Using an Example

To understand how this works, let’s look at a basic example. Let’s say you’re one of four members in an LLC that own a pro rata share of a commercial building. As a group, the LLC is considering selling the property within the next year – for simplicity, we’ll say the asking price is $1,000,000.

The other three members of the LLC are looking to pay taxes and receive net sales proceeds on the sale – but in your case, you want to put your portion toward another investment property using a 1031 exchange. Here are some important factors in your Drop and Swap transaction:

  • Timing: It’s possible to try a Drop and Swap right before the 1031 exchange, but doing so increases your risk of an IRS audit – as such, the earlier the better here. Doing this at least one year in advance of the closing of a replacement property is the general recommendation. Please note that there are not official established timelines determined by the IRS.
  • Filing an election: After the transition has been made from LLC to tenants in common, and while waiting for the property to be sold, you will file a Section 761(a) election. This is a notification to the IRS that you and your former LLC partners (now tenants in common) do not want to be taxed as a partnership.
  • Periodic payments: If possible, to help provide a pattern that proves you are no longer partners and are instead tenants in common, make regular payments of operating expenses.
  • Negotiate as individuals: Negotiate and engage the sale agreement as individuals, not partners. This will allow the person pursuing the 1031 exchange to do so with their percentage interest of the net sales proceeds applied to their sale.

This can be a complex process, and you want 1031 exchange advisors on your side. We invite you to contact us at 1031 Exchange Place – we’d love to help!