Structuring an individual partner’s 1031 exchange through the “Drop and Swap” method - by Brendan Greene

Brendan Greene, Greater Boston Exchange Co.

The continuing strong real estate market in the Greater Boston area and throughout New England has given investors substantial equity in their properties subjecting them to higher capital gains taxes on the sale of such properties.  Consequently, more investors, both U.S. and foreign, are using 1031 tax-deferred exchanges in order to defer paying capital gains taxes. 

Internal Revenue Code (IRC) Section 1031 provides “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.”

We are frequently asked whether partners in a partnership (typically members of a limited liability company) can enter into a 1031 exchange transaction to defer the capital gains tax on their percentage interest in the partnership when other partners just want to sell and pay their individual taxes.

Section 1031 specifically excludes partnership interests as assets which can be exchanged. As a result, in order to allow individual partners to exchange, the transaction must be very carefully structured. There are a number of structures used to do this and the most common structure is the so called “drop and swap”.

In a typical “drop and swap”, the partner first drops out of the partnership by accepting a deed for a tenant in common interest in the property equivalent to the percentage interest in the partnership, and the partner then exchanges or “swaps” the tenant in common interest in the property for a replacement property.

There are a number of tax considerations and other factors which must be addressed to properly structure a “drop and swap”. In order for property to be exchanged, it must have been held by the taxpayer for use in a business or for investment.  The IRS has challenged and disallowed exchanges where the timing of the drop is very close to the swap or exchange. The argument of the IRS is that the property was not “held” for a significant enough period of time to be considered held for investment purposes. Therefore, the longer the tenant in common interest is held prior to the sale and exchange, the better the chance is of having a successful exchange.

There are also reporting requirements under Partnership Tax Form 1065 that went into effect in 2008, which require a partnership to report a distribution of a tenant in common interest to a partner. As such, it is better tax practice to convey out to the partner in a tax year prior to the year in which the sale of the property takes place in order to enhance the holding period requirement.

Additionally, the IRS has successfully argued in many cases that if property held in tenant in common ownership has the attributes of a partnership, the tenancy in common ownership will continue to be considered a partnership and would disqualify an exchange by “drop and swap”. The degree of continuing management by the holder of a tenant in common interest in the property is probably the biggest factor in a long list of factors that the IRS uses to determine what constitutes de facto partnership. The least amount of management by the co-owners is recommended to avoid designation as a de facto partnership. Co-owners should consider appointing a single co-owner as management agent for the group or hire an outside management company.

For other various reasons, tenant in common agreements should be entered into to spell out the respective rights and obligations of the tenants in common. The IRS provides guidance on these agreements in the form of Rev. Proc. 2002-22. These agreements are helpful in rebutting the argument of a deemed partnership.

The technique of “dropping” an interest to a partner in the form of a tenant in common ownership of title to the property and then “swapping” that interest is constantly evolving. As such, there are several important planning steps that can be taken in order to structure the exchange transaction with the best chance to survive a challenge by the IRS.

Brendan Greene, Esq. is the co-owner and co-operator of the Greater Boston Exchange Company, LLC (a subsidiary of McCue, Lee & Greene, LLP), Boston.