How To Do a 1031 Exchange When Breaking Up a Partnership

Purchasing real estate with other investors can open new opportunities – it can allow investors to access larger assets and higher return potential. However, investing with other people can present some challenges. One of the most common issues facing partners is deciding what to do when they want to sell the asset. More specifically, what should investors do when they have different opinions on how to distribute the proceeds from the sale of the property?

Generally, when investors sell a real estate asset, they are required to pay capital gains – taxes on the profit from the sale of the property. However, the Internal Revenue Service (IRS) offers investors a unique tool to sell their real estate assets and defer capital gains. To do so, however, the entity holding the property must be the same entity purchasing the next property.

How can partners accomplish this when they disagree on what to do? They can restructure their ownership by leveraging a “drop and swap.” 

What is a 1031 exchange?

Before diving into the details of a drop and swap, let’s first look at the basis for a 1031 exchange. A 1031 exchange, also known as a “like-kind exchange,” is outlined in Internal Revenue Code (IRC) Section 1031 and states that property owners can exchange real property used for business or held as an investment solely for another business or investment property that is the same type or “like-kind.”

Individuals, C corporations, S corporations, partnerships (general or limited), limited liability companies, trusts, and any other taxpaying entity may qualify for a 1031 exchange. 


The Drop and Swap

The IRS does not allow partners to sell or dispose of their partnership interests while deferring taxes if they acquire like-kind replacement property. However, a workaround solution exists in the form of the “drop and swap.” This practice allows a subset, or portion, of a partnership or LLC to engage in a 1031 exchange without the need for all parties to participate in it.

Investors can “drop” their current ownership structure and “swap” for a tenancy in common (TIC) interest. This allows investors to redistribute the proceeds from the sale of the property independently of each other.

Let’s look at an example. Alex, Kelly, and Jeff are partners in an LLC that owns real property, and they decide it is time to sell based on current market conditions. However, Alex and Jeff want to reinvest the proceeds from the sale via a 1031 exchange while Kelly is ready to cash out.

If the property is sold while held in the LLC, the only way Kelly can cash out is by the entire LLC cashing out; this results in Jeff and Alex paying capital gains before they can reinvest the proceeds. 

A drop and swap, by contrast, allows the partners to drop the entity, which means the real estate is now owned through a TIC, and each investor can use their portion of the funds following the sale of the property according to their individual investment plans. Jeff and Alex can reinvest via a 1031 exchange, deferring capital gains, and Kelly can cash out and pay capital gains. 

Advantages of the Drop and Swap

There are two key advantages to using a drop and swap. First, it provides investors with some additional flexibility to maneuver around their competing priorities. Second, it allows them to defer paying taxes until a later date. In addition, the 1031 Exchange process can be completed over and over, indefinitely, until the investors determine that they want to pay the taxes. 

Rules of the Drop and Swap

Because a drop and swap is not officially approved by the IRS, it can be extremely risky to undertake one, and the IRS could disallow the exchange if the entity swap was done incorrectly. To help ensure that a 1031 exchange is permissible, investors would generally follow these guidelines and always consult their lawyer prior to doing anything:


Completing the Exchange

It is important to note that anyone completing a 1031 exchange needs to follow the rules of the exchange as outlined in IRC Section 1031.

Proceed with Caution and Prepare in Advance 

Parting ways is sometimes necessary among partners. Goals and objectives change, and new investment strategies emerge. While a drop and swap appears to be the solution to ownership problems in a 1031 exchange, all parties involved – especially those who want to complete a 1031 exchange and defer capital gains – should proceed with caution.

Any time investors change from one form of ownership to another, it is important to get professional help. Since there is no guarantee that the IRS will approve the exchange, it is highly recommended that everyone involved speak with a tax specialist or 1031 expert prior to selling the real estate.

Do you need to be an accredited investor to invest in REITs?

What does being an accredited investor means?

There is no process of becoming an accredited investor. You don’t  need to apply for a license or pass a test to qualify as an accredited investor. Instead, your wealth or to be precise your annual income determines your accreditation. As per the Securities and Exchange Commission (SEC), to qualify as an accredited investor, an investor must have an individual income of more than $200k per year or a joint income of $300k. Many real estate investment structures accept only accredited investors and non-accredited investors can’t invest there.

What is Real Estate Investment Trust (REIT)?

A Real Estate Investment Trust or REIT is a private trust that owns, and in most cases, operates income-producing real estates. REITs have large institutional-grade properties in their portfolio. Some REITs invest in the commercial sector, while some are inclined towards the healthcare sector. The majority of REITs lease spaces to tenants and receive rents on those properties. Whereas, some REITs lend money to real estate investors and  earn interests on the mortgages and mortgage-backed securities. With benefits akin to that of mutual fund investment, REIT investment offers a steady flow of income for a long time.

Do I need to be an accredited investor for investing in REITs?

No, you don’t need to be one. Any investor can invest in REITs irrespective of how much wealth they possess. You can invest in a REIT just like you invest in the stocks of other companies. The majority of REITs are listed with the Securities and Exchange Commission and trade on the National Stock Exchange. Shares of a REIT can be easily bought and sold on the National Stock Exchange. As a REIT’s shareholder, you’ll be subject to receive dividends like other shareholders.

What are the different types of REITs?

There are three major kinds of REITs where you can invest –

How to plan a REIT investment?

Though you can invest in a REIT with the help of a broker, you may want to consult your financial advisor or a REIT expert before that. As shares of a REIT can be bought and sold on the National Stock Exchange, a REIT investment is subject to market risks.