One of the things I find most interesting about the law is how flexible it can be. In many areas of law—and particularly in business law—even though the facts of a case may seem to point very firmly toward a certain outcome, there exists an option that can be used to create an entirely different result.
Our law provides many backdoor avenues, alternative routes, and subterranean pathways that can be used to produce all sorts of unexpected consequences. We see this at work with contingency clauses in 1031 exchange contracts. These tools can help “steer” a transaction in a more desirable direction. The flexibility of our law leads to greater complexity, but it also increases the likelihood that you’ll be able to put yourself in a good position.
Aside from contingency clauses, another example of the flexibility of our system is the so-called “drop and swap” technique, which is used by partnerships. As we know, section 1031 cannot be invoked by partnerships (see Internal Revenue Code subsection 1031(a)(2)(D)).
But this prohibition does not mean that the members of a partnership entity have no possibility of ever exchanging their ownership interests in a 1031 exchange. Members can execute a drop and swap, which will allow them to disassociate themselves legally from the partnership and then use their interests in an exchange.
Let’s go over the basic mechanics of drop and swap 1031 exchanges and then discuss some of the hurdles members are most likely to face when engaging in this type of practice.
Using Drop and Swap 1031 Exchanges to Overcome Partnership Exclusions
If the members of a partnership wish to participate in a section 1031 transaction, the drop and swap method is among the most common means to get over the partnership exclusion stated in subsection 1031(a)(2)(D).
The mechanics of a drop and swap are pretty straightforward: for the property owned by the partnership to qualify as a relinquished property, the members must first convert their interests into a tenancy-in-common (TIC) arrangement. Converting to a TIC serves the dual purpose of giving the property section 1031 eligibility and also allowing members who wish to “cash out” to sell their undivided fractional interest.
In any given drop and swap scenario, one or more of the partners may want to simply sell their ownership interest and avoid the future 1031 transaction. The TIC arrangement allows members to do this without interfering with 1031 eligibility. If a member does sell his or her interest, then he or she must pay the required amount of tax.
After those members who do not wish to partake in the 1031 exchange have been “dropped,” the remaining members can then proceed to swap their interest for their desired replacement property. So, in many ways, a drop and swap follows the same trajectory as a traditional TIC 1031 exchange. With a drop and swap, though, certain members may depart from the transaction and cash out their interests.
What’s more, drop and swaps also carry other risks that aren’t typically seen with other TIC transactions.
Risks to Be Aware of with Drop and Swap 1031 Exchanges
Drop and swaps carry a number of risks you should be aware of. Some of these risks can be difficult to mitigate, so it’s very important that you exercise a great deal of caution when undertaking a drop and swap.
One of the biggest risks relates to the “held for” requirement of section 1031. The property must be held for investment or for productive use in business or trade to be eligible for a 1031 exchange. Partners risk losing section 1031 treatment if they sell their interests too quickly after they develop a TIC arrangement. Section 1031 treatment may also be denied if partners develop a sales contract for the property while it is still owned by the partnership (prior to the TIC).
To mitigate this risk, after breaking down into a TIC arrangement, it is best for members to wait for at least a short amount of time (i.e. several months) before selling the relinquished property. Members should also be sure not to develop a sales contract prior to the TIC formation. Please consult your tax advisor.
Drop and swaps can be very useful for partnership members who would like to engage in a 1031 exchange. But drop and swaps can be a bit tricky, especially if members face tight time constraints. At CWS Capital Partners, we have specific experience with drop and swap 1031 exchanges and would be happy to help you navigate the process and minimize your risk.
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The information provided here is for your general informational purposes only. It should not be considered a recommendation or personalized advisory advice. CWS has made this third party information available from authors it believes are knowledgeable and reliable resources. However, its accuracy or completeness cannot be guaranteed and sentiment may change due to legal or economic conditions.
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