When all the partners don’t agree on what to do with the proceeds from the sale of real property, executing a “drop and swap” allows real estate investors to “drop” real property ownership from the LLC to individual partners as tenants in common (TIC) prior to selling the real property. The “drop” to individual partners as TIC should take place prior to the sale, allowing as much time as possible for the property to be “held for business or investment purposes” by the individual tenants. As with all 1031 exchanges, there is no clear rule in the tax code about how long before a sale the property must be owned by the tenants in common.
When the property is sold (the “swap”), the proceeds are divided among the TIC. Each individual can then decide whether to cash out and pay taxes or reinvest into another investment property and continue to defer taxes.
Revenue Ruling 77-337 and Revenue Ruling 75-292 provide examples of exchanges that were disqualified due to transfers which occurred immediately before or after an exchange from or to an entity controlled by the taxpayer.
Partners will want to ensure that the partners not involved in the 1031 Exchange (those that want to cash out) truly drop their interests in the partnership. If not, the IRS may recharacterize their TIC interests to partnership interests. Refer to Rev. Proc. 2002-22 for minimum “drop and swap” criteria.
Be aware of two questions on the Form 1065, Schedule B:
Question 13 asks
“…during the current or prior tax year, the partnership distributed any property received in a like-kind exchange or contributed such property to another entity (other than entities wholly-owned by the partnership throughout the tax year)”
Question 14 asks
“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?”
It is best to negotiate and take title as individuals rather than entities.
Disclaimer: The information provided above is not meant to be legal or tax advise. You should consult your CPA and attorney to determine the best course of action for your situation.
Mitzi E. Sullivan, CPA is a cloud based professional services provider specializing in cloud accounting.