Drop & Swap in a 1031 Exchange Explained for Investors

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Key Takeaways

  • 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, they 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 it 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.

At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers. Over the years, we have accumulated a significant amount of experience helping investors place their 1031 Exchange funds. If you are an accredited investor, looking to participate in a 1031 Exchange, and would like to learn more about our current investment opportunities, click here.

What is a 1031 Exchange?

In order to understand a Drop and Swap, 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:

  • Purchase Price: The purchase price of the Replacement Property must be equal to or greater than the price of the Relinquished Property.
  • 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.
  • 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?

In short, a Drop and Swap 1031 Exchange is a solution to the issue of partners who do not want to reinvest their sales proceeds.  It 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?

As the name suggests, 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.

So, in the most simplistic sense, a Drop and Swap 1031 Exchange is a workaround for the requirement that the taxpayer be the same in both the sale and purchase transactions. While it 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.

Holding Period Requirement For a Drop and Swap

One of the key requirements for completing a 1031 Like Kind 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 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

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

There are two key advantages of a drop and swap.

First is the 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.

Second, it provides investors with some additional flexibility to maneuver around the competing priorities of investment partners.

Drawbacks to Consider

Like any real estate investment strategy, there are risks to consider in a Drop and Swap.

The most notable 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.

Second, there are time constraints under which the 1031 Exchange must be completed. They 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

From the description of the benefits, it should be clear why an investor would be interested in a drop and swap transaction. The prospect of deferring taxes indefinitely can allow investment capital to grow tax free over time, which is a major advantage for long term investors.

Interested In Learning More?

First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.

If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.

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