It is common for groups of investors who jointly own rental properties to structure their ownership as a Liability Limited Company (LLC) partnership. We often receive calls from partners requesting information on how to utilize the 1031 exchange process to defer taxes on a contemplated sale and there is often a surprise when they learn that all partners in the LLC must move in lockstep together to purchase replacement properties.
Under applicable IRS tax code, LLC partnership interests are not exchangeable, and the titleholder of record i.e., the LLC that sells the relinquished property, must acquire the replacement property. For example, if the three LLC partners of a rental property sell the property, that same partnership must buy and hold title to the replacement property. Individual partners who wish to leave the partnership and independently buy a replacement property for themselves with their share of the exchange will disqualify their exchange.
“Drop and Swap” is an industry term that describes a process that would potentially allow LLC partners to independently complete 1031 exchanges without being tied to approval from the other partners. The process begins by first dissolving the LLC partnership and then reformulating it into Tenant-in-Common (TIC) ownership structure. The distribution of LLC common interests in the property to the individual partners in the form of a TIC is called a “drop.”
When the restructured rental property is sold, each TIC owner can then use their pro rata sales proceeds to independently purchase or trade into qualifying 1031 replacement properties (“the swap") thereby differing their tax obligations, or they can take the cash out of the exchange and pay taxes on whatever portion that is not exchanged.
A real estate investor doing an exchange has the obligation to show that they have an “intent to hold” the property as long term investment. While the IRS does not define the minimum required holding period for an acquired property, most tax advisors recommend a minimum holding period of two tax years or longer.
What would happen if you decided to “drop and swap” after receiving a sales offer or near to the time when the property will be put up for sale?
In those circumstances there is heightened risk that the tax authorities would disallow the exchange and argue that your intent was not to hold but to avoid paying taxes.
If you have a loan on your property, plan on seeking approval from your lender prior to initiating a drop and swap. There may be fees charged by your lender to review applicable documents – or they may simply refuse to allow the change in ownership structure. Since each TIC investor is a borrower, the lender is likely to conduct a financial review of all investors and also require a new property appraisal. Lender approvals can take a significant amount of time to occur, and a successful outcome is often not guaranteed.
If you own property in an LLC but wish to have the added flexibility for you and your other partners to potentially go separate ways in the future, a drop and swap may be a solution worth exploring. Be aware that a drop and swap is a complicated transaction that will require close cooperation with all stake holders. Below are some practical tips that we have learned from investors and their CPAs and attorneys.
For more information on 1031 exchanges and suitable 1031 replacement properties, please contact us today for a free consultation.
Disclaimer: While we generally believe the information in this blog to be accurate, we can make no assurances and advise all readers to check with their personal legal and accounting advisors to determine applicability in specific investor situations.
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