Tax Update: The Drop-and-Swap Gets a Win!

Tax Update:
The Drop-and-Swap Gets a Win!

The IRS recognizes a partnership as a single entity, a single person. This “person” may exchange real estate, but the individuals who make up the partnership may not exchange their individual shares. This creates a problem when one or more persons wish to break out of the partnership and go on their own without paying capital gains tax. The conversion of the partnership to a Tenancy in Common or “TIC” allows the investor to accomplish the desired exchange. There are two basic solutions to navigate.

“Drop and Swap”
The drop and swap approach describes an exchange where a partnership interest is converted to TIC before the exchange takes place. The question of timing is the largest issue in this technique.

“Swap and Drop”
The swap and drop approach describes an exchange where a partnership interest is converted to TIC after the exchange takes place.

Gagne v. Gagne: A Court Ordered Drop-and-Swap

Written by Lee David Medinets

In Gagne v. Gagne, 2019 WL 1284883 (Colorado Court of Appeals, Division V, 2019), the appellate court reviewed and approved a trial court’s order to dissolve four LLC real property holding companies owned by a mother and her son, and then to swap TIC interests in those assets so that mother and son would each own a fee interest in two of the four properties.

Paula Gagne and her son Richard Gagne acquired four apartment buildings in Fort Collins, Colorado. Each apartment building was held in the name of a separate LLC. All funds for the purchase of these apartment buildings came from Paula. Their agreement called for evenly dividing all profits after Paula received the return of her capital investment. The trial court expressly found that a specific purpose of these investments was to give Richard and his family a livelihood operating these properties through HSI, a real estate management company owned by Richard. Paula and Richard could not get along, and, as the trial court found, Paula wrested control of the companies from Richard, ceased doing business with HSI, and engaged in extensive inappropriate self-dealing.

The trial court found that the LLCs could not effectively function because of Paula’s self-dealing and because she had frustrated a fundamental purpose of these LLCs by refusing to do business with HSI. Therefore, the trial court ordered the LLCs to be liquidated and the properties to be divided between the parties through an IRC § 1031 drop-and-swap transaction. The following table summarizes the court’s calculations:

In order to accomplish this distribution, the court ordered the LLCs to be liquidated, making Paula and Richard tenants in common, and then it ordered the appropriate tenancy in common interests to be exchanged between them, with Richard’s $107,182.06 cash balancing the transaction. Paula appealed on numerous grounds. For our purposes, the most important ground was her argument that an IRC § 1031 was an inappropriate way to distribute this property. The appellate court disagreed.

Paula argues that even if an in-kind distribution isn’t barred by the operating agreements, the type of in-kind distribution contemplated by the district court – a drop and swap 1031 exchange – isn’t appropriate because (1) the Act’s[1] provisions allowing for in-kind distribution don’t allow such a distribution to be accomplished in this way; (2) section 1031 doesn’t allow an exchange of limited liability company property; and (3) even if section 1031 allows such an exchange, it won’t work here. These arguments don’t require any extended analysis, because each fails for very straightforward reasons.

The appellate court flatly contradicted Paula’s first argument, that the Act does not allow for in-kind distribution as tenants in common of LLC property “in this way.” Here, the trial court was particularly justified in doing so:

The court’s decision to do this through a temporary creation of tenancies-in-common and subsequent transfers of these interests from each member to the other was driven by the parties’ treatment of the four LLCs as essentially one business.

That finding is interesting because it suggests that facially separate tax partnerships may be considered to constitute a super-partnership for certain purposes, specifically including IRC § 1031 exchange purposes. Regarding Paula’s second argument, that “1031 doesn’t allow an exchange of limited liability company property,” the appellate court made the appropriate distinction:

The experts testified that swapping membership interests [Italics are original] for each other or for real property can’t qualify for section 1031 treatment. But at least one of them testified that once the properties are owned by tenants-in-common, they qualify for section 1031 treatment. So the district court ordered a process – involving initial transfers to the members as tenants-in-common – which will allow the parties to take advantage of section 1031 if doing so is something they want to pursue.

Concerning Paula’s third argument, that a 1031 exchange would not work in this case, the court stated:

In arguing that a 1031 exchange won’t work, Paula points to a number of contingencies or steps that would need to occur, such as IRS approval, careful planning, and involvement by banks and title companies. She doesn’t argue, however, that these are insurmountable obstacles. And, in any event, such an exchange is expressly contemplated by section 7B of the operating agreement and is merely an option the court is allowing the parties to pursue. Though Paula says she will suffer negative tax consequences as a result of “los[ing] her gain in each LLC,” she offers no legal argument in support of that contention. Nor does she explain how negative tax consequences could be avoided while still winding up the LLCs.

There is a great deal that I, for one, would like to see clarified in this last statement. However, the bottom line is that the Colorado Appellate court expressly approved a drop-and-swap in this case.

Caution should be exercised in relying on this case too strongly for several reasons. First, this is a state court case that was focused primarily on the state law issue of what remedies are available to dissolve a limited liability company. This is not a tax case. Second, there are some indications that the tax issues may not have been fully briefed and considered. Third, the case is not yet officially published.

On the other hand, the case is remarkably similar to the situation that was discussed and approved by the Tax Court in Mason vs. CIR, T.C. Memo 1988-273 (US Tax Court, 1988). Official publication of this Gagne case is eventually likely. Gagne may therefore serve as additional weight to the argument that drop-and-swap transactions are an ordinary IRC § 1031 planning tool.

Disaster Extensions

Mary Foster, Esq., CES, Tax Committee Chair

45 and 180 DAY EXTENSIONS FOR DISASTER AREAS IN ALABAMA, IOWA, AND NEBRASKA

Alabama: The IRS has issued an extension for the Lee County beginning March 3, 2019.

Iowa: The IRS has issued an extension for Fremont, Harrison, Mills, Monona and Woodbury counties beginning March 12, 2019.

Nebraska: The IRS has issued an extension for Butler, Cass, Colfax, Dodge, Douglas, Nemaha, Sarpy, Saunders, and Washington counties beginning March 9, 2019.

The Disaster Date is in bold. Listed counties are the “Covered Disaster Area”. [Please check the IRS disaster website periodically at the address listed below for updates because the FEA does not send out notices for each disaster or for counties added to ongoing disaster extensions.]

Both of the following criteria must be met to get the extension under Revenue Procedure 2018-56, section 17:

(1) The taxpayer is located in the Covered Disaster Area or is otherwise an affected taxpayer as defined in the Notice, regardless of where the relinquished property or replacement property is located, or otherwise has difficulty meeting the exchange deadlines under the conditions in Revenue Procedure 2018-58, section 17; AND

(2) The relinquished property was transferred (or the parked property was acquired by the EAT in a reverse exchange under Revenue Procedure 2018-58) on or before the Disaster Date listed in the Notice. Note that some disasters occur on a single date; others, such as flooding, occur over a period of days and the Disaster Date above is preceded by beginning.

IF the taxpayer meets these criteria, THEN any 45 day or 180 day deadline that falls on or after the disaster date is extended to THE LONGER OF: (1) 120 days from such deadline; OR (2) the extension date listed in the Notice. Note the date may not be extended beyond one year or the due date (including extensions) of the tax return for the year of the disposition of the relinquished property (typically, if an extension was filed, 9/15 for corporations and partnerships and 10/15 for other taxpayers).

Please see Revenue Procedure 2018-58, Section 17, and the Notices at https://www.irs.gov/newsroom/tax-relief-in-disaster-situations.

Please contact Equity Advantage today if you have further questions or concerns on these topics.

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