A common question we encounter around 1031 is – I am looking to utilize exchange benefits, but a few of my business partners wish to cash out – what options do I have? Can I opt for a 1031 exchange in a partnership?
Ideally, the answer is ‘yes’ – applying a system called the “Drop and Swap.” However, some essential requirements need to be followed.
- 1031 exchange has a general rule that for a transaction to pass as ‘like kind,’ the seller of the property and the one who replaces it, needs to be the same person. Also, whoever owns the title for the relinquished property must be on the title of the new property.
- Also, per IRS Section 1031(a)(2)(D), interests in partnerships are not exchangeable – and, the interest has to be transitioned to a tenant in common interest prior to availing a 1031 exchange.
Basic Issues You Might Encounter
Ideally, this is quite an easy option; however, at times, it can get complicated. If you’re part of a trust, partnership or LLC, where other members plan to cash out, but you or other individuals prefer to opt for a 1031 exchange to defer capital gains, the most common procedure here is the “Drop and Swap.”
In a Drop and Swap event, you’re “dropping” yourself from the partnership and, it shifts into a tenant in common relationship with your partners. Then you can “swap” into a replacement property. In principle, a Drop and Swap changes the property title in the partnership, excluding individual names to complete the transfer.
Let’s get a better understanding through an example. Let’s suppose you’re one of four members in an LLC that own a pro rata portion of a commercial building. As a group, the LLC is contemplating selling the property in the next year for an asking price of $1,000,000.
The other three members of the LLC wish to pay taxes and receive net sales proceeds on the sale; however, you plan to use your portion in acquiring another investment property for a 1031 exchange. Here are essential factors for your Drop and Swap transaction:
- Timing: It’s plausible to attempt a Drop and Swap right before a 1031 exchange, however doing so exposes you at a risk of an IRS audit – hence, the earlier, the better! It is recommended to plan this at least one year before the closing of the replacement property. Kindly note that this is not an official established a timeline by the IRS.
- Filing an election: After the transition from an LLC to tenants in common, and while you are waiting for the property to be sold, you need to file a Section 761(a) election. This is to notify the IRS that you and your former LLC partners (now tenants in common) do not wish to be taxed under the partnership.
- Periodic payments: Try to present a pattern that confirms you are no longer partners and are tenants in common. Making regular payments for operating expenses is an excellent way to go about it.
- Negotiate as individuals: Engage and Negotiate the sale agreement not as partners but as individuals. This will enable the person completing the 1031 exchange to do so with their percentage interest of the net sales proceeds applied to their sale.
Drop and Swap can be a bit tricky, you should seek expert guidance to ensure the process goes smoothly. Speak to our advisors at 888-993-2835 or email us at email@example.com.