Drop and Swap 1031 Exchange: A Guide for Real Estate Investors

Investing in real estate with partners in an LLC is a popular way to grow your wealth, but it comes with kinks. When it’s time to sell and some of the partners want to cash out while others want to take advantage of a 1031 exchange to continue to defer taxes, what can you do?

Limited liability companies (LLCs) are great in that their income is taxed as "pass-through income" and they can defer capital gains taxes by using like-kind exchanges. However, 1031 exchanges have several governing clauses that determine how exchange transactions work and which LLCs are eligible for 1031 swap transactions.

Since partnership LLCs present significant tax planning challenges for partners and their tax advisers, the IRS doesn't allow partners to sell or dispose of their partnership interests while deferring taxes if they acquire like-kind replacement property.

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However, there's a workaround in the form of the “drop and swap” strategy.

What Is a 1031 Drop and Swap?

Drop and swap allows real estate investors to "drop" their ownership structure out of an "entity level" to a co-ownership – turning former partners into tenants in common. When the property is sold, the proceeds are divided proportionally, and co-owners can now either cash out and pay their taxes or reinvest into another investment property through a qualified intermediary (QI) and still defer taxes.

In these types of transactions, co-owners and multi-member or partnership LLCs can sell a property, allocate the proceeds, and still purchase a new property.

Are Drop and Swaps Legal?

Yes, a drop and swap is legal. Partnership interests fall under the definition of personal property, which unfortunately can't be exchanged under the Internal Revenue Code IRC 1031 and can't be used to acquire real estate of a like kind.

However, a partnership can still do a 1031 exchange of investment property on the entity level, meaning that the entire partnership has to sell the relinquished property, purchase the replacement property and still defer taxes for as long as it remains intact.

The reason for this is that Section 1031 requires that exchanges of partnership property be handled by the same taxpayer, which applies to partnerships as long as they do not change their compositions prior to acquiring a new property as described above.

1031 Exchange with Multiple Owners

Assets held by LLCs, multiple partners and tenants in common can be exchanged in 1031 exchanges as long as each owner mutually agrees to relinquish the property and complete a 1031 exchange.

Can I Sell a Property I Co-Owned and Do a 1031 Exchange with Just My Portion?

In short, yes, as long as all co-owners mutually agree to sell the property. However, if you don't employ a drop and swap, you might be liable for capital gain taxation.

An Example: Dissolution of Partnership in a 1031 Drop and Swap

Let's consider the following scenario. Fred, Bill and Jill are partners in an LLC that owns real property. Let's say that all three partners agree that they want to sell the real estate but disagree on what to do with the proceeds.

For example, Fred and Bill want to roll the proceeds into a new property through a 1031 exchange, while Jill wants to take the cash generated from the sale — cash out.

Two of the following things may happen:

1. The real estate is sold by the partnership LLC, and the proceeds will be distributed to Fred, Bill and Jill, and all parties will be taxed. While this is OK for Jill, Fred and Bill are now left with less money to invest in a new property.

2. The real estate is exchanged through 1031 exchanges, and the relinquished property is exchanged for a new one. No cash was received, as all equity went into the acquisition of the new property, and thus no taxes were assessed. While this is OK for Fred and Bill, Jill still hasn't cashed out.

The Drop and Swap

Drop and swap exchanges fill this need.

A drop and swap allows Jill to transfer her membership interest to the LLC (Fred and Bill) and receive a percentage ownership interest in the property that's equivalent to her relinquished membership interest.

This "drops" the ownership of the real estate from the "entity level" to tenancy in common interest (TIC) between an LLC (Fred and Bill) and Jill. When the property is eventually sold, the co-owners will be allocated the proceeds pro rata. Jill would receive cash from the title company and pay taxes, and the LLC (Fred and Bill), can transfer their proceeds to the qualified intermediary and swap them into a new property, deferring taxation.

However, it's also worth noting that the standard 1031 transaction rules and time frames apply to an LLC looking to perform a like-kind exchange.

A potential third scenario would dictate that Fred and Bill, as partners in an LLC, and Jill want to roll into different properties. Then a more complicated, reverse version of drop and swap is used, called "swap and drop" — however, these are rarely used.

Drop and Swap Holding Timing

One would be wise to seek tax and legal counsel about the time between the entity is restructured into a TIC (tenants in common) and a subsequent sale and exchange. The IRS may disallow the exchange if the drop and swap was done just before the sale, and there is no clear rule in the tax code about how long before a sale the drop and swap can be performed.

This is where an investor must lean upon the advice of a qualified CPA who has experience with 1031 exchange rules and the drop and swap strategy.

Can You Do a 1031 Exchange after Closing?

Generally you cannot do this, because 1031s require qualified intermediaries (QI). However, you could rescind the transaction in the same tax-reporting period and contact the buyer to agree to rescind the transaction. When the transaction is rescinded, the IRS will treat the sale as if it never happened; the taxpayer receives the property back from the buyer, and the buyer receives the full purchase funds from the taxpayer.

You can then file for a 1031 exchange and repeat the sale. Rescission has long been recognized in law in relation to transactions other than 1031 exchanges. The Internal Revenue Service, on the other hand, has authorized rescission to be used to fix a fault with an exchange transaction.

This is not to be confused with a reverse exchange. A reverse exchange means the reverse of a conventional delayed 1031 exchange: Instead of selling your old property and then buying a replacement, you buy your replacement property first, and then sell your old property.

The reverse 1031 exchange works for investors who have a great, time-sensitive opportunity to buy and have to act fast to secure the property.

Key Takeaways

Drop and swap structures are useful for dissolving partnerships, where parties want to go their separate ways, cash out or simply invest in different properties.

Make sure you talk to your CPA and attorney about this strategy well before you attempt to restructure your entity and sell your property to make sure you are in compliance with the 1031 exchange IRS rules and regulations.