Like Kind Exchange Drop and Swap

Section 1031 of the Internal Revenue Code is often used by a taxpayer who wishes to avoid paying capital gains taxes upon the sale of real and personal property. Under Section 1031 a taxpayer may enter into an exchange in lieu of a traditional sale and defer any capital gains tax that would be due if the transaction were a traditional sale. There are a number of requirements that must be met for a transaction to qualify as a Section 1031 exchange including:

  • The property must be held for productive use in a trade or business, or for investment
  • The property must be exchanged for “like-kind” property
  • The entire exchange must be completed within 180 days
  • A Qualified Intermediary, or QI, must be used to facilitate the exchange, with the exception of a two-party exchange

Partnership Interests

While a Section 1031 Exchange may be completed using a wide variety of different types of property, Section 1031(a)(2)(D) specifically excludes partnership interests from the types of property that may be used to complete a 1031 Exchange. This exclusion has spurred a significant amount of litigation as taxpayers attempt to structure a transaction that works around the exclusion.

The issue often arises when a partner in a partnership, for example, wants to structure a Section 1031 Exchange using property owned by the partnership but wants to enter into the transaction separate from the partnership. The reverse may also be the case if the owner of property wishes to contribute the property to a partnership after the exchange. The problem in either case is that the property is held as an ownership interest in the partnership which does not qualify for a 1031 Exchange.

Drop and Swap

The partner may attempt to change the ownership of the property just prior to the exchange, or just after the exchange, so that the transaction meets the requirements of an exchange. Commonly referred to as a “drop and swap” or “swap and drop” these transactions can be difficult to structure so that they qualify for Section 1031 treatment. Such was the case in Chase v. Commissioner, 92 T.C. 874 (1989). In that case, Petitioner was a partner in a partnership that purchased an apartment complex. Approximately a year later the value of the property had dramatically increased prompting the sale of the property; however, Petitioner wished to avoid paying capital gains taxes on the estimated $7 million in realized gain. Toward that end, just prior to the closing on the apartment transaction Petitioner caused the partnership to distribute an undivided interest in the apartment representing a liquidation of his interest in the partnership. The idea was that the subsequent “sale” of the apartment would be treated as a Section 1031 Exchange with regard to Petitioner’s interest. Ultimately the Tax Court held that the “substance over form” doctrine applied and that although the technical requirements of a Section 1031 Exchange may have been met the transaction was a “fiction that failed to reflect the true economic reality of the situation.” In reality, Petitioner’s role with regard to the property never changed from that which it had been as a partner, causing the court to determine that the change of ownership was a fiction designed solely to provide a way around Section 1031(a)(2)(D).

Also consider TAM 9818003 where a partner in a partnership wished to acquire one of the partnership properties for himself. For the partnership to avoid capital gains on the sale of the property to the partner, they agreed to a Section 1031 Exchange. A QI was used and the relinquished property transferred to the partner. The agreement called for a suitable replacement property to be located and transferred through the QI back to the partnership pursuant to the requirements of a Section 1031 Exchange. Instead of receiving a replacement property, however, the partnership received the cash proceeds from the relinquished property. Although the partnership immediately turned over the cash to the QI for the purchase of a replacement property which was then deeded back to the partners to liquidate their partnership interests, the transaction did not qualify for tax deferral because the partnership never actually held the title to the replacement property. Therefore, the partnership did not complete the Section 1031 Exchange.

If you wish to enter into a “drop and swap” or “swap and drop” Section 1031 Exchange be sure to seek professional advice to ensure that you structure the transaction in a way that will qualify for tax deferred treatment. Be sure to consider whether the “drop and swap” triggers IRS interest when responding to questions 13 and 14 in Schedule B of Form 1065.

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