It’s common for small business owners and real estate investors to join with individuals who share common goals to purchase and manage real estate. This strategy could open up opportunities for building wealth and diversifying a real estate portfolio. However, it’s possible that partners’ goals may change over time as investment needs evolve and the market fluctuates, particularly when it comes time to sell the property or properties.
One or more partners may want to cash out of their share, while others may want to reinvest in new real estate. In this case, it can be difficult for every investor to exit the sale while getting what they want and avoiding taxation. This article reviews how these partnerships may benefit from a 1031 drop and swap transaction.
What Is a 1031 Exchange?
A 1031 exchange is a tax strategy and investing tool real estate investors use to swap one investment property for another so they can defer paying capital gains taxes on the sales income of the property they sold. Generally, investors would pay a capital gains tax at the time of the sale.
With a 1031 exchange, investors can use the proceeds from their relinquished property to reinvest in a newer, better, or more valuable property to conduct business or another type of investment. Real estate investors commonly use this strategy to “trade up” or upgrade their existing properties without paying tax on the proceeds. You may hear this term used as a verb, such as, “I want to 1031 this apartment complex for another.”
Sometimes, a 1031 exchange may be called a like-kind exchange or a Starker exchange. A like-kind exchange, as stated by the Internal Revenue Code in Section 1031, is when an investor exchanges a property used for investment or business purposes for another property used for investment or business. For example, an investor may exchange a single-family rental home for an office building because they have the same intended use of renting to tenants.
While this strategy can offer many benefits, the IRC Section 1031 also has several guidelines that investors must follow to ensure their exchange remains valid and eligible for 1031 exchange tax deferral. The tax implications and time frame stipulations can be problematic for investors looking to conduct a 1031 exchange.
What Is a Drop and Swap, and How Does It Work?
A drop and swap is a 1031 exchange strategy that allows business partners or investors in an entity to have several exit possibilities. This enables all investors to cash out, do a 1031 exchange, or take whatever action they wish by dropping their interest in the partnership. In a traditional 1031 exchange, partners in an entity must agree on what they will do with the proceeds of selling the property because they own an interest in the entity that owns the real estate — the individuals do not own the real estate themselves.
If the entity itself executes the exchange and follows the guidelines to reap the tax benefits, all individuals within the partnership will experience the same outcome. However, if one or more partners want to cash out instead of exchanging the property for another, a drop and swap allows them to do so.
When the partners “drop” their ownership of the real estate in the entity — through distribution or liquidation — the entity will be terminated, and the partners will own the property as co-owners or tenants in common (TIC). From here, they can sell the property.
Since the entity no longer owns the real estate, Partner A, who wishes to cash out, will receive the cash from the title company. Partner B, who wants exchange benefits, can “swap” the property by giving the sales proceeds to a qualified intermediary (QI) who will hold the funds in escrow until Partner B identifies a replacement property. This way, Partner A will receive the money and pay taxes, while Partner B can reinvest in a new business opportunity.
Drop and Swap Requirements
One of the most critical requirements of a drop and swap is that investors must hold the property or properties involved in a drop and swap for business or investment use for a certain period. Though the tax code under Section 1031 doesn’t explicitly state an exact holding period, investors or partners should generally hold the property for a reasonable length of time after the partnership dissolution before executing a sale and drop and swap.
If the investors don’t hold the property long enough, the Internal Revenue Service (IRS) may suspect the investors of “flipping,” or trying to resell a property for a quick profit, and invalidate the exchange. Investors should wait at least two years before conducting the drop and swap since the 1031 provision is only for investment or business properties.
For a drop and swap to work properly, investors need to use a QI to help with the exchange and drop and swap strategy, hold the proceeds, and ensure the partners abide by the tax guidelines.
Here are some other important factors to consider in a drop and swap transaction:
- Election filing: Once the partnership is dissolved into a TIC agreement, the investors must file a Section 761(a) election so the IRS knows to no longer tax the partnership.
- Operating expenses: To help prove to the IRS you are no longer a partnership, all investors should make equal payments of the property’s operating expenses.
- Negotiation: When it’s time to sell the property, the investors should negotiate the sale agreements as individuals instead of partners. This will allow the partner or partners interested in a 1031 exchange to follow that procedure with their sales proceeds.
Pros and Cons of a Drop and Swap
Let’s review the general benefits and challenges of a drop and swap real estate transaction.
Executing a drop and swap comes with two primary advantages. The first is a tax deferral for the partner or partners who wish to complete a 1031 exchange. This allows the investors to defer capital gains taxes on their share of the sales income of the property. The investors who use the 1031 exchange route can conduct the exchange process as many times as they want, with certain time restrictions between exchanges, until they decide to sell for cash. Savvy investors use the 1031 exchange to defer taxes and build wealth.
The second benefit of a drop and swap is it allows the investors in the partnership to gain flexibility while navigating their partners’ different needs and investment goals. These competing priorities can be challenging to manage, and a drop and swap process enables partners to have their own exit strategy.
The most notable disadvantage of a drop and swap is the risk of completing the transaction within the limits of the IRS guidelines. Several complications can arise when navigating a 1031 exchange, such as holding the property for sufficient time and ensuring the partners who want to swap properties find one that meets the IRS requirements. A 1031 exchange is a complex process with many moving parts and requires hiring a professional to facilitate the transaction correctly.
Getting any of these requirements wrong will disqualify the transaction and cause all partners to pay taxes on their share of the profit.
The second challenge is the time constraints within the 1031 exchange. Investors who wish to reinvest in another property must identify a replacement property within 45 days of selling the former property. In a competitive market, this could cause an investor to feel pressured and settle for a property that doesn’t truly fit their investment goals. In addition to identifying a replacement property in 45 days, the investor must purchase the new property within 180 days of selling the old property.
Finally, investors must remember that if they own real estate through a corporation, the liquidation would be taxable, which could eliminate the advantages of a drop and swap. This same challenge will also occur if the property’s value is not high enough to account for legal fees and other expenses.
Drop and Swap vs. Swap and Drop: Is There a Difference?
An alternative to the drop and swap method is the swap and drop method. This technique occurs in the opposite direction of a drop and swap, much like a reverse 1031 exchange is the inverse of a delayed 1031 exchange.
In a swap and drop 1031 transaction, the partnership would conduct a traditional 1031 exchange of their co-owned property. The investor who wants to exit the partnership would cash out after the exchange. Essentially, the partner who wants to cash out would go along with the 1031 exchange to purchase the replacement property and own a share of it until they wish to exit.
Learn More With 1031 Crowdfunding
Investors in a partnership have alternatives when it comes to exiting their entity or cashing out. A drop and swap process may enable all partners to work toward their investment goals individually, even with conflicting interests. At 1031 Crowdfunding, we offer an extensive online marketplace of vetted 1031 exchange properties that can help investors identify their replacement property within the required timeline for their exchange to remain valid.
Our goal is to support real estate investors in their endeavors and guide them through the 1031 exchange process so they can defer capital gains taxes and reinvest in a new opportunity. We invite you to register for an account today to receive support from our team of experts who can assist you in making well-informed decisions for your business and investment purposes. You can also visit our education center to learn more about the 1031 exchange process.
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