Dissolution of Partnerships in a 1031 Exchange: The Drop and Swap

Written by admin on May 21st, 2011

When you sell your interest in investment property, you may incur federal capital gains taxes and, in some states, state taxes as well. Your attorney, tax advisor, or real estate professional may suggest a tax-deferred exchange under Section 1031 of the Internal Revenue Code.  A 1031 tax-deferred exchange allows you to dispose of investment properties and acquire “like-kind” investment properties while deferring federal capital gains taxes and depreciation recapture. Most states with a capital gain tax offer a similar tax advantage, too. 

However, coordinating a 1031 exchange for limited liability companies or partnerships can present a unique set of challenges for investors.  If the entity itself will remain intact, the partnership or the LLC can sell its property and purchase replacement property through the 1031 tax deferred exchange process.  However, a common issue that arises is that not all of the members or partners can agree on replacement property to purchase, or even if they want to do a 1031 exchange at all. 

Investors in this situation often use a “Drop and Swap” structure to complete their transaction.  This term applies to dropping the property out of the LLC or partnership to the individual members, and then each member could do a 1031 exchange or “swap” into their own replacement property.  Although this method has been applied for years, there are some risks to be aware of.

The biggest risk with this type of transaction is that, if audited, the individual members may not be able to show that the property was held for productive use in a trade or business or for investment as Section 1031 requires.   In other words, the individual members only held title for a short time and only with the intent to sell the property.  Therefore, the “held for” requirement of Section 1031 may not be considered met.

Click here to learn more about risks involved with drop and swaps, recent developments, and tips for structuring your 1031 tax-deferred exchange.

First American Exchange Company is a Qualified Intermediary and is precluded from giving tax or legal advice.  As with any transaction, taxpayers should consult with their tax professional about their specific circumstances.  

Contact us to set up your next 1031 exchange!


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