1031 Exchange: Drop and Swap Analysis

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Drop and swap, or changing the entity on title to reflect partner names and their partitioned interest, is a tax deferral strategy deployed in 1031 exchanges requiring proper planning and understanding of the federal tax implications. The consequences of a poorly implemented drop may result in an Internal Revenue Service (IRS) audit and civil and criminal penalties if the intent is to defraud or evade taxes. Tax fraud is defined as “the actual intention of wrongdoing, and the intent to evade a tax believed to be owing. Fraud implies bad faith, intentional wrongdoing, and a sinister motive.”

Drop and Swap

Drop and swap involves changing the property title in a multi member partnership or limited liability company to reflect the addition of one or more of the individual members. This is the “drop,” followed by a 1031 exchange where the members may defer capital gains taxes while others cash out and pay taxes. The IRS is taking a closer look at tax returns where the drop does not allow for adequate hold time.

Every 1031 exchange has intent to hold the property in a trade, business or for investment (known as proper intent) along with facts that support the taxpayer’s intent. How the real property is titled and the duration of the hold time are two such facts. When the title is changed, the hold time is effectively reset. If the hold time is changed prior to a 1031 exchange, the Court may interpret this as an inadequate hold time to support the proper intent. The Court also recognizes tax avoidance is legal and the right of every taxpayer to keep taxes as low as possible.

IRS Form 1065

In 2008, the IRS changed the United States Return of Partnership Income Form 1065 by adding questions 13 and 14 to Schedule B. Question 13 seeks to identify returns where the partnership engaged in a like-kind exchange during the current or prior year and received replacement property, and then distributed ownership its interests to an entity other than a disregarded entity during the current tax year. 

Question 14

In question 14, the IRS asks whether “at any time during the tax year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property?” Tenancy-in-common, or fractional ownership interest, is reflected as the partners’ names on the property title.

For example, the partnership Atlas 1031 Exchange drops two partners to tenancy-in-common by changing the title to Andy Gustafson as to an undivided 27 percent interest, DeVan Dade as to an undivided 26 percent interest and Atlas 1031 Exchange as to an undivided 47 percent interest.

If the partnership partitions ownership to its partners to be jointly owned, question 14 must be answered yes.

Best Practices

Suggestions to perfect the drop include:

• If there is an indication that partners no longer can get along, consider making the change now in preparation for an eventual sale.
• Receive income distributions as tenants in common as well as pay the taxpayers share of operating expenses.
• Drop at least a year in advance of listing the property for sale.
• Enter the sales contract as tenants in common, meaning each partner signs under their individual names while the general partner signs on behalf of the partnership.
• Notify the IRS that the co-owners elect not to be taxed as and has dissolved the partnership.

All too often, the partner intent on initiating a 1031 exchange is prevented from the drop by the partnership because the probability of an IRS audit increases with a poorly timed drop. Understanding and acting upon the recommendations before the property is listed for sale enables the 1031 exchange option.

Related articles of interest include:

• Are Partnership Interests Eligible for 1031 Exchanges?
• Partnership Interests, Limited Liability Companies: 1031 Exchanges
• 1031 Exchange Rules: Multiple Owner Insight

Call our office to discuss your transaction and seek the financial counsel of your attorney and CPA.