We have talked before about the drop and swap exchange and how it can be beneficial in certain like-kind exchange situations. In this article, we are going to explain the inverse of the drop and swap exchange – the swap and drop 1031 exchange.
What Is a 1031 Swap and Drop?
A swap and drop 1031 exchange is essentially the reverse of a drop and swap exchange.
To quickly review – a drop and swap exchange is a 1031 exchange tactic often used by taxpayers in a partnership. If there are 3 partners who own a piece of real property, but only 2 of them wants to do a 1031 exchange on the property, the partners can convert their interests in the property to tenancy-in-common interests. This allows the odd partner out to cash out their share, while the remaining 2 partners conduct a 1031 exchange to reinvest into another investment property through a qualified intermediary (QI) to defer taxes.
In a swap and drop exchange, the partners would conduct the 1031 exchange selling the property (the swap) and then later distributes the replacement property (the drop) to the partners. Partners may prefer to engage in a “swap and drop” if they are concerned about the risk of a “drop and swap,” especially if a sale of the relinquished property is already in progress. Both the drop and swap and swap and drop techniques need to be carefully constructed in order to be successful.
In acquiring replacement property in these transactions, each partner designates a separate replacement property to be acquired by the partnership. Following the acquisition of the replacement properties, the partnership continues in operation for some time.
After an appropriate amount of time has passed following the exchange (evidencing that the replacement property is held for investment and not for distribution to the partners), the partnership then distributes the replacement properties to the respective partners as part of a tax-free partnership distribution. In order to facilitate the “swap and drop,” the separate replacement properties are often acquired in the name of single-member LLCs wholly owned by the partnership, and the partner who is designated to eventually receive that LLC is often designated as the manager of the LLC.
Before engaging in a swap and drop 1031 exchange, the partners should consider some important issues:
- Depending on the number of partners involved, it may be complex to carry out the exchange. Consider that the more partners and replacement properties that must be acquired, the more coordination and planning will be required, including decisions regarding identification of replacement property, closing multiple acquisitions, and ensuring proper allocation of exchange proceeds among the acquisitions.
- The partners will need to decide how long the replacement properties should be held before being distributed. While there is no specific rule on this, generally the shorter the period of time, the greater the risk that the IRS or FTB may disallow the exchange.
Takeaways
Swap and drop 1031 exchanges are useful for dissolving partnerships, where parties want to invest in different properties.
Be sure you speak to your CPA and attorney about this strategy well before you attempt to restructure your entity and sell your property to ensure you are in compliance with the 1031 exchange IRS rules and regulations.
If you’re interested in exploring the option of Buying a Home in Columbus, Ohio please give us a call at 614.332.6984 and we’d be happy to assist you!
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