Curious about the partnership interest rules that accompany a 1031 exchange? Look no further! Join David Moore in our latest blogcast update, where we cover the various methods to nail your exchange game.
Drop and Swap
An exchange where a partnership interest is converted to TIC before the exchange.
Swap and Drop
An exchange where a partnership interest is converted after the exchange. As of 2009 the IRS is tracking pre and post 1031 contributions and distributions of partnership interests.
What You Will Learn or Learn from the Expert(s):
- Why when it comes to exchanging, the person or entity relinquishing the property must be the same person or entity receiving the replacement property.
- Why any changes in vesting must be made before or after the exchange and the appropriate seasoning period must be established.
- 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.
David Moore: Hello, David Moore, equity Advantage, 1031exchange.com. And we are going to talk about some 1031 slang, the drop and swap and swap and drop. Well, what am I talking about? Well, 1031 is over 100 years old at this point.
One of the things that it really does not allow you to work with is partnership interest. They’re specifically excluded from 1031 treatment. So, it’s not uncommon for a group of people to go out and buy a property and do it via limited liability company. Depending on the size of the deal, actually, the lender may require that.
But the important thing to understand is you cannot exchange into a partnership interest, nor can you exchange out of a partnership interest. So oftentimes we’ll have these things created and they’re easy to create and they’re hard to get rid of. So, need to understand that if you’ve got a group of people that own an asset and now it’s a few years later, you’ve owned this thing and somebody wants out, or maybe you’ve just realized it’s time to sort of turn that property.
Well, in that situation, if everyone’s going forward together as the LLC, that is fine. But if we’ve got the members or a member of the limited liability company that wants to go different directions, we’ve got to deal with it. Now, a logical situation could be maybe we have five people in the LLC and one or two want to go away.
Well, we’ll keep the two or three in that LLC and that’s fine. The entity would go forward, the people that want to go away would be dropped out via just a deeded out of that entity. So, from the membership interest now into a tenancy in common, and then those two people that are going away can either pay the tax or they could do an exchange. Now, I have to caution you a little bit because if there’s a drop, typically these drops happen at closing.
And the reason that drop, so this is a drop & and swap we’re talking about right now. It happens at closing for a couple different reasons. One, nobody’s thought about it. Two, it’s sort of expensive and can be time consuming, cumbersome to do it maybe year in advance.
So, I’ll have a meeting. It’s not uncommon for me to have a meeting with the taxpayers and their tax and legal counsel, maybe a year pre-sale if we actually have time to plan it. I’ll walk out of that meeting with everybody on the same page. We’re going to break it into a tenancy in common, hold it for a year, and then relinquish it tenancy and common wise.
And then we’ll get a call that the deal’s pending. And that didn’t happen. So, I still see a purchase sale agreement between the entity and the buyers. And so, I’ll go back and say, well, gee, why wasn’t that thing changed?
And it’s because, well, you got rental agreements, loans, maybe you got acceleration provision, the loan that’s going to be hitting you, tax returns, a variety of different things. The lease agreements, for example, all those things would have to be changed to the Tenancy and common structure, and it just doesn’t happen. So, nine times out of 10, it happens while things are pretty close to closing and the vulnerability there. And as I said, if we’ve got, let’s say two people drop out of that LLC, those two people, they in effect have a reset on their holding periods.
Now, understand 1031 does not have a required hold, but you know, typically people are going to say maybe a year. You might hear a lot of people say, you got to hold a property for two years. The code says that. It doesn’t. If I’m your brother and we’ve swapped properties, that’s a related party transaction, and we’ve got a two year hold there.
But if you read the fine print, even in a related party transaction, if there’s no intent to avoid tax, that that two year hold doesn’t apply. So, understand that anytime we’ve got a change in ownership, we’ve got that happen.
Now you might say, well, there’s, hey, there’s three or four of us in the LLC and one person wants to go forward, so just keep the one person in the LLC and they can go forward. Well, the LLC went from a partnership to a disregard entity when it went to one.
Now, in a community property state, you could keep spouses in it and still go to one. In a non-community property state even spouses, you’d have multi-member, it would be a partnership in a non-community property state. But if you’ve got a shift in that filing nature of the entity, you’ve got to reset on the hold period.
So that pre-sale drop to tenancy and common is typically the way it happens because people just don’t want to go forward together. Now, let’s say that people aren’t comfortable with immediate predisposition drop into the tenancy and common, then we’ll do what we call a swap and drop. And then the way I like to do that is if we let’s say we’ve got five members, go out and buy five different properties. One for each party, that, that will ultimately want each property.
But instead of them, taking ownership, which they can’t, we’re going to have the exchanging entity, that legal partnership, the LLC with the five is going to go forward as the member of maybe five different LLCs, a new LLC for each asset. And why would we do that? Because maybe a year post acquisition at that point, or whatever you and your tax people agree is a reasonable period of time, we’re going to then do an assignment of membership interest from the entity to Peter on this property, Suzie on this one, Daniel and CC and David and Tricia, okay?
So, I mean, we’re going to drop it after the acquisition. So, we swap, we do the assignment of membership interest from the entity to each of those people individually for their respective properties. Now, we didn’t have to have a title change, therefore the title policy’s still in place, everything else. So that’s sort of the way I like to do it, is to have that entity buy into each of the replacement properties via single member LLCs that can then be assigned over to the respective owner in the future.
So that’s sort of in a nutshell, the drop and swap is predisposition drop to tenancy in common. A swap and drop is a post 1031 drop from the entity into those respective ownerships at the end of the day. Now you’ll understand the other reason. So, the two reasons that the swap and drop don’t happen as much probably one is people just don’t get along. They don’t want do it. But number two, if there’s lending involved there, then sort of everybody’s sort of encumbered by those loans.
David Moore: So those are things you’ve got to look at. There’s no perfect answer that that immediate predisposition drop from the LLC into the tenancy in common. It’s definitely preferable way, but you are vulnerable if you look at the transaction and say, okay, now we potentially have that reset and ownership from the entity to the individuals. So be aware of that.
And if you’ve got further questions on this topic, please don’t hesitate to reach out. I did not give you black and white solutions on any of these. It’s all about options, and that’s what we’re going to talk about. David Moore, equity Advantage, 1031exchange.com. Thank you for tuning in.
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Whether working through a 1031 Exchange with Equity Advantage, acquiring real estate with an IRA through IRA Advantage or listing investment property through our Post 1031 property listing site, we are here to help Investors get where they want to be. Call them today! 503-635-1031.