The “Drop & Swap” Alternative In A 1031 Exchange

Partners in an LLC selling real property may be bracing to receive the sale proceeds and pay capital gains tax. But what happens when the partners disagree on the exit strategy and one or two partners want to continue deferring taxes? Fortunately, there is a strategy known as “Drop and Swap” where partners can drop their ownership structure out of the entity-level LLC, become tenants-in-common with each owning proportional shares, and allow the former LLC partners to make their own choice to either cash out, or reinvest using a 1031 exchange and continue deferring taxes.

Four Steps of Drop and Swap

1. Decision to Sell: Partners agree to sell real property held in the LLC but discover there isn’t complete agreement among all partners as to how sale proceeds should be handled.
2. Tenancy in Common Agreement: Partners agree to exit the LLC and become tenants in common with each partner now able to choose to either receive cash proceeds and pay tax or reinvest using a 1031 Exchange.
3. Complete the Sale: Exiting partners either receive their cash proceeds, or partners electing to use a 1031 Exchange have their proceeds received by a Qualified Intermediary.
4. Complete the Exchange: 1031 Exchangers complete the purchase of their replacement property within 180 days of the sale of the LLC’s real property.

With a Drop & Swap, it is recommended to prepare the property being sold for separate exits before signing a listing agreement with a real estate brokerage. It is important to handle the details delicately as it is not as simple as switching over the deed. Attorneys must consider a tax-compliant agreement, insurance policies must be changed, leases assigned, and a resolution to liquidate the entity executed. Also, the legal department of the lender will have to change the borrower for any existing debt from the entity to the TIC.

There are scenarios where the Drop & Swap wouldn’t be an appropriate alternative. A few examples would be when the property is held in a Corporation or S Corp, or the heirs of an estate have been bequeathed the property, or the value of the sale is simply not high enough compared to the expenses in a “micro deal.” However, there are other solutions we would be happy to discuss on a case-by-case basis. For more information schedule a call today!