• A drop and swap 1031 exchange is a type of transaction that allows real estate investors to defer capital gains taxes on the profitable sale of an investment property as long as they reinvest the proceeds into another property that is considered to be “like kind” to the one that was sold.
• The “drop and swap” part of the transaction is particularly relevant when a property is owned by a partnership and one (or more) partners do not want to reinvest sale proceeds.
• The major benefit of a drop and swap is the tax deferral, but it comes with risks. These are complicated transactions with a lot of rules. Getting it wrong can disqualify it from full tax deferral benefits.
• Because they are complicated transactions, it is always recommended that 1031 exchange investors work with a qualified intermediary and/or CPA and tax advisor.
Commercial real estate assets are expensive. As such, it is uncommon for them to be solely owned by a single individual. Instead, commercial properties are most commonly purchased using limited liability corporations or partnerships, where a number of people come together to pool their money to close the transaction.
With regard to partnerships, a profitable sale of an investment property can create an interesting scenario. Partners are happy because they sold the property for a profit, but they may be less happy when it comes time to pay taxes on their gain. In order to defer taxes, the partnership can reinvest the sales proceeds into another property using a program known as a “1031 exchange.” But what happens if some partners want to reinvest and others don’t?
We’ll answer that question in this article by explaining a type of 1031 exchange known as a “drop and swap.” We’ll describe what a drop and swap 1031 exchange is, how it works, the requirements for completing one, and the pros and cons of doing so. By the end, readers should have the information necessary to determine if a drop and swap 1031 exchange may be a good fit for their individual real estate needs.
First Off, what is a 1031 Exchange?
In order to understand a drop and swap 1031 exchange, it is helpful to begin by first describing what a 1031 Exchange is in general.
A 1031 exchange is a tax deferral program, so named after section 1031 of the Internal Revenue Code (IRC), that allows investors to defer capital gains taxes on the profitable sale of an investment property (the “Relinquished Property”) as long as they reinvest the proceeds into another property of “like kind” (the “Replacement Property”).
In order to achieve full tax deferral, the IRS requires taxpayers to abide by a number of key rules for 1031 Exchanges:
1: Purchase Price: The purchase price of the replacement property must be equal to or greater than the price of the relinquished property.
2: Time: In the 1031 Exchange transaction, the exchanger must identify their replacement property within 45 days of the sale of the relinquished property. And they must close on the purchase of it within 180 days of the sale date.
3: Taxpayer: Perhaps most importantly for the purpose of this article is that the taxpayer must be the same in both the sale and purchase transactions. In other words, it must be the same legal entity.
On this last point, problems can arise when a partnership sells a property and some of the partners want to reinvest the proceeds, and others don’t because the partnership must remain intact to purchase the Replacement Property. The solution to this issue is the “drop and swap” 1031 exchange.
What is a Drop and Swap 1031 Exchange?
A drop and swap 1031 exchange is a workaround for the requirement that the taxpayer in a 1031 exchange be the same in both the sale and purchase transactions. A drop and swap 1031 exchange is a solution to the issue of partners who do not want to reinvest their sales proceeds. This type of 1031 exchange involves some legal maneuvering that allows for the dissolution of the partnership that owns the property and the reinvestment of sales proceeds for those partners who choose to participate in the exchange.
How Does a Drop and Swap 1031 Exchange Work?
The drop and swap 1031 exchange can be broken into two parts, the “drop” and the “swap.”
In the “drop”, the partnership is dissolved prior to the sale of the relinquished property and the tenants in common interests are distributed to each individual partner. Then, these individual owners deed the partnership property to the individual or entity who intends to buy it.
In the “swap”, the former partners who wish to reinvest their sales proceeds “swap” their partnership interests for a share of the replacement property. The owners who do not wish to reinvest the proceeds can keep their share and go their separate ways, but they will be required to pay taxes on the gain.
While a drop and swap 1031 exchange may be suitable in multiple circumstances, it is most prevalent in a scenario where a partnership was used to purchase a property (as opposed to a Limited Liability Company) and, upon sale, some partners want to reinvest the proceeds, but others don’t.
What is the Holding Period Requirement for a Drop and Swap 1031 Exchange? One of the key requirements for completing a 1031 exchange is that the properties involved must be held “for productive use in a business or for trade or for investment.” Unfortunately, the IRS does not provide for a specific period that a property must be held until it is considered to be for investment purposes. So, in a drop and swap 1031 exchange there is a risk that the IRS could disallow the exchange into the Replacement Property if the dissolution of the partnership occurs too close to the closing of the sale of the property.
In order to make sure all involved in the drop and swap 1031 exchange comply with the holding requirement, it is a best practice to work with some combination of a qualified intermediary (QI), certified public accountant (CPA), and/or tax advisor with specific expertise in this type of transaction.
“Other Requirements for a Drop and Swap 1031 Exchange”
In addition to the holding period requirement, there are a number of other rules that real estate investors should consider when entering into a drop and swap 1031 exchange:
Election Filing – Once the partnership has been dissolved (dropped) and the transition to tenants in common (TIC) interest is complete, an election (761(a)) must be filed with the IRS to notify them that the ownership entity should no longer be taxed as a partnership.
Operating Expenses – To help prove to the IRS that the individuals involved are no longer partners, and instead tenants in common, each should pay their pro rata share of the property’s operating expenses for a certain amount of time.
Individual Negotiation – When it comes time to sell the property, the former partners/co-owners should negotiate their sale agreement(s) individually. Doing so will allow each individual interested in the 1031 Exchange to do so based on their ownership interest.
Again, a 1031 exchange is a complicated transaction, a drop and swap especially so, and these requirements are not meant to be comprehensive. Real estate investors should always work with a Qualified Intermediary/CPA to ensure that their tax return is filed correctly and to make sure that all transaction rules are followed.
“Advantages of a Drop and Swap 1031 Exchange”
There are two key advantages of a drop and swap.
1. Tax Deferral
Completion of a successful 1031 exchange allows investors to defer capital gains taxes on the profitable sale of the property. In addition, the 1031 exchange process can be completed over and over, indefinitely, until the investor(s) determines that they want to pay the taxes.
A drop and swap 1031 exchange provide investors with some additional flexibility to maneuver around the competing priorities of investment partners.
Drawbacks of a Drop and Swap 1031 Exchange
Like any real estate investment strategy, there are risks to consider in a drop and swap.
1. Execution Risk – The most notable drawback to drop and swap 1031 exchanges is the execution risk that goes along with completing the transaction within the bounds of the IRS rules. There are many potential complications to navigate and getting one of them wrong could disqualify the transaction and cause it to become taxable. This is why it is important to work with a Qualified Intermediary or CPA to make sure it goes smoothly.
2. Time Constraints – There are time constraints under which the 1031 exchange must be completed. These constraints can put investors under a great deal of pressure to identify a suitable replacement property and, in the most competitive markets, could cause them to “settle” for something that may not be the best fit for their preferences.
Both of these issues can present potential complications in the transaction, which underscores the need to work with experts, to plan carefully, and to pay attention to the calendar.
Why Investors May Consider a Drop and Swap – The prospect of deferring taxes indefinitely from a drop and swap 1031 exchange can allow investment capital to grow tax free over time, which is a major advantage for long-term investors.
Wai-Yew Lam, TREC instructor & Qualified Intermediary