When a partnership owns real estate and plans to sell it, the individual partners often disagree about whether to set up an exchange or cash out, and whether they want to acquire something together or go their separate ways. If all of the partners want to exchange and invest in replacement property together, the solution is fairly simple since the partnership can set up the exchange. If some partners want to cash out or exchange separately, a more creative solution is required. The partnership owns the exchangeable asset, i.e., the real estate. The individual partners each own a partnership interest, which cannot be exchanged under the 1031 rules. A solution is required to get the exchangeable real estate asset into the hands of the partners for them to be able to exchange.
Drop and swap
The most common solution is the structure referred to as a “drop and swap.” In a drop and swap, the partnership deeds a tenant-in-common interest in the property to the partners who want to break away. Once the individual partners own the real estate directly, they can exchange or cash out separately from the partnership. In some cases, the partnership may be terminated and all of the real estate deeded down; in other cases, the partnership will be maintained and only some of the partners branch off.
Swap and drop
There is also a procedure called a “swap and drop” which involves the partnership doing an exchange and then after the exchange, deeding a portion of the property to the partners who want to own something separately. For example, a partnership with three partners might acquire two properties as replacement property, and then after the exchange, deed one of those to the partner who wants to leave the partnership.
Do these strategies work?
There are 1031 and general partnership tax issues to pay attention to when structuring solutions to partners wanting to go their separate ways. For example, the IRS may argue that the individual partner who receives the property in a drop and swap is not the true owner of the property, or that the partner never held the property for investment purposes because at the time of the exchange, the partner intended to immediately dispose of it. In addition, it may be argued that, based on the step transaction doctrine, the parties actually exchanged real estate for a partnership interest rather than for like kind real estate.
These transactions may be challenged but there is also case law supporting them. For example, see
Magneson v. Commissioner of Internal Revenue, 753 F. 2d 1490 (9th Cir. 1985), Bolker v. Commissioner of Internal Revenue, 760 F. 2d 1039 (9th Cir. 1985) and Maloney v. Commissioner of Internal Revenue, 93 T.C. 89 (1989), which all upheld drop and swaps or swap and drops on the theory that the taxpayer is continuing essentially the same investment even though there has been a change in the form of ownership.
Even in California, where the Franchise Tax Board has been aggressively auditing exchanges, the State Board of Equalization recently unanimously overruled the Franchise Tax Board’s disallowance of an exchange where there was a swap and drop. In this case (In re Rago Development Corp., 2015-SBE-001, June 23, 2015), the taxpayers traded out of property and into replacement property as tenants-in-common, and seven months after the exchange, formed an LLC and contributed the property into it, as required by their lender. The LLC was owned by all of the same tenant-in-common owners and the SBE held that the swap and drop didn’t disqualify the exchange.
Conclusion
Many tax advisors recommend that the “drop” portion of a drop and swap occur before the seller enters into a contract to sell the property. Although it isn’t always practical, some recommend that there be an extended time period between the drop and swap, or swap and drop and that during this time the parties behave in a manner that is consistent with how the ownership is set up. In other words, if the individuals own the property as tenants-in-common, don’t treat them for tax purposes as if they are still partners in a partnership. There is authority to support these structures which is based on the fact that the taxpayer continues to own the same investment under a different form of ownership.
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