“Drop-and-swap” Problems with 1031 Exchanges

Structuring transfers of property for partnerships or limited liability companies without running afoul of the 1031 exchange rules can present problems. It's a common problem because you seldom can get all of the owners of a property to agree on the same course of action.

For example, Fred, George and Howie are equal partners in the FGH Partnership, which owns an office building they are under contract to sell. George and Howie want to sell the property, take their share of the proceeds and pay the tax. Fred, on the other hand, wants to do a 1031 exchange into a small apartment building he's found.

Since the office building is owned by one tax return (the partnership), Fred could not buy the apartment building in his name because the entity that sold the Old Property has to do the exchange and buy the New Property. This means that the partnership would have to buy it, which isn't possible since George and Howie are cashing out of the partnership, which will then legally cause it to dissolve. The end result is, under this scenario, Fred cannot do a 1031 exchange.

To get around this problem, Fred's attorney suggests he do a "drop-and-swap." By this he means the partnership should "drop" the title to Fred's share out of the partnership and into a tenant-in-common interest in Fred's name. In other words, Fred now owns a share of the building rather than a share of the partnership. And since his share of the building is in his own name, he can do a 1031 exchange (which is where the "swap" comes in) and take title to the New Property in his own name as well. Or can he?

...we can expect an increase in these types of attacks.

In the past, the IRS has attacked drop-and-swap arrangements from two primary directions. With their recent announcement that they are going to audit more exchanges, we can expect an increase in these types of attacks. The most likely attack will be that Fred did not hold the property for investment. Section 1031 requires that to complete the exchange the property must have been "held for investment" and not for resale.

Typically, the held-for-investment requirement means that you have to hold the property for at least one year and one day, which Fred obviously hasn't (not in his name anyway). You would think that Fred could add the time he owned the property through the partnership to the time he owned the property individually. But he can't, because it's two different tax identification numbers.

Another approach the IRS has used to successfully attack these types of exchanges is to attack them as a "step transaction." Section 1031 does not allow you to do a 1031 exchange on the sale of a partnership interest. The IRS has had some success arguing that if you ignore the drop part of the transaction, what you've effectively tried to do is a 1031 exchange on the sale of a partnership interest. So they collapse the steps to disallow the exchange.

If your only shot at a 1031 exchange is a drop-and-swap (as is the case with Fred), there are some things that you really must do to lessen the chance that the IRS will disallow your exchange.

The first, and most important thing you need to do is to get your share of the property dropped out of the partnership as early as possible. This should be done before the property is listed, and absolutely must be done before you have a contract on the property.

Don't be sloppy--dot your i's and cross your t's! Make sure all your paperwork is in order. Record the deed showing your ownership in the property as soon as it is prepared. Don't wait just because you don't want to have to pay transfer tax.

Another thing that is really important is to file what the IRS calls a Section 761(a) election. This notifies the IRS that you and the other co-owners of the property elect to NOT be taxed as a partnership. It's a powerful statement to them that you do not want to be a partnership.
During the period that you and your former partnership are co-tenants, make sure that you receive periodic checks for your share of the income from the property. You should periodically pay your share of the operating expenses as well.

All of this is very important because there is now a much greater chance of having to fight with the IRS over your transaction. As I've said, the IRS is going to audit a greater number of exchanges. In addition, the IRS has added two changes to Form 1065 (the tax form that partnerships and LLCs file). This form will now ask whether you did a drop-and-swap. And they've beefed up the penalties they will now impose on Fred's attorney for how he structured the transaction.

One last thing: corporations cannot do a drop-and-swap. This is because their laws are different. And a drop-and-swap can result in double taxation--without any cash (because of the exchange) with which to pay the tax.

So if you're like Fred, and have no choice but to do a drop-and-swap, be sure to fully implement the above suggestions. It's not bulletproof, but with a competent QI that has both accounting and legal skill sets, your odds of succeeding improve dramatically.