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.

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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:

Holding Period – Investors should ensure they allow a long enough holding period for the partnership to be in a TIC. Of those reporting that a drop and swap did not allow them to defer capital gains, many explain that a short holding period may have been the issue. The IRS tends to prefer the property be held for a longer period of time in order to qualify for a 1031 exchange.
Election Filing – Once an ownership structure is dropped and swapped for a TIC interest, an “election” must be filed with the IRS. According to IRC Section 761(a), an election allows the entity to avoid being categorized as a partnership.
Operating Expenses – To show that the real estate is no longer held in a partnership, all investing parties should pay their pro rata share of the property’s expenses. The longer the period, the better the case will appear to the IRS.
Negotiations – When it is time to sell, each investor needs to negotiate on their own behalf. Those who want to trade via a 1031 exchange need to make it known during the sale of the initial property.

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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.

The exchange must be completed within a strict time frame. From the day the initial property, or “relinquished property,” closes, an investor has 45 days to identify a “replacement property” and 180 days to close on it.
The total value of the relinquished property, equity and debt, must be reinvested to defer paying the taxes; any amount not reinvested is taxable.
All replacement property must meet either the 3-Property Rule, the 95% Rule, or the 200% Rule.
According to the 3-Property Rule, investors can select up to three properties, of any value, as replacement properties and purchase one or all of them.
According to the 200% Rule, investors can identify any number of properties as replacement properties as long as their aggregate fair market value does not exceed 200% of the relinquished property’s aggregate fair market value.
According to the 95% Rule, investors can identify as many properties as they want so long as they purchase at least 95 percent of all identified replacement properties’ aggregate fair market value.
All exchanges must use a qualified intermediary (QI). A QI, or exchange facilitator, is an independent person, company, or entity that enters into a written agreement with the investor to facilitate the transfer of proceeds. It is important to use a QI because proceeds held by any party that is not a QI are taxable.

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.