Investing in real estate with partners in an LLC is a popular way to grow your wealth, but it comes with downsides. When it’s time to sell and some partners want to cash out while others want to take advantage of a 1031 exchange to continue deferring taxes, what can you do?

Limited Liability Companies (LLCs) are great in that their income is taxed as “indirect income” and they can defer capital gains taxes using like-kind exchanges. However, 1031 exchanges have several governance clauses that determine how exchange transactions operate and which LLCs are eligible for 1031 exchange transactions.

Because LLCs present significant tax planning challenges for partners and their tax advisors, the IRS does not allow partners to sell or assign their partnership interests while deferring taxes s they acquire similar replacement goods.
However, there is a workaround in the form of “let go and trade” strategy.

What is a 1031 Drop and Swap?

Drop and swap allows real estate investors to “drop” their ownership structure from “entity level” to co-ownership – turning former partners into joint tenants. When the property is sold, the proceeds are divided proportionately and the co-owners can now either collect and pay their taxes or reinvest in another investment property through a Qualified Intermediary (QI) while deferring the taxes.

In these types of transactions, co-owners and LLCs or partnerships can sell a property, split the proceeds, and purchase a new property.

Are drops and swaps legal?

Yes, a drop and swap is legal. Partnership interests fall under the definition of personal property, which unfortunately cannot be traded under Internal Revenue Code IRC 1031 and cannot be used to acquire real estate of the same nature.

However, a partnership can still perform a 1031 investment property exchange at the entity level, which means that the entire partnership must sell the abandoned property, buy the replacement property, and defer the taxes as long as it remains intact.

The reason for this is that Section 1031 requires that exchanges of partnership property be handled by the same taxpayer, which applies to partnerships as long as they do not change their composition before acquiring new property as described above. -above.

1031 exchange with multiple owners

Assets held by LLCs, multiple partners and tenants in common may be exchanged in 1031 exchanges as long as each owner mutually agrees to relinquish ownership and complete a 1031 exchange.

Can I sell a property that I co-own and do a 1031 exchange with Just My Portion?

In short, yes, provided that all the co-owners mutually agree to sell the property. However, if you do not use a drop and swap, you may be subject to capital gains tax.

An example: the dissolution of a partnership in the context of a surrender and exchange 1031

Consider the following scenario. Fred, Bill and Jill are partners in an LLC that owns real estate. Let’s say all three partners agree that they want to sell the property but disagree on what to do with the proceeds.

For example, Fred and Bill want to transfer the proceeds to a new property via a 1031 exchange, while Jill wants to withdraw the money generated from the sale – cash out.

Two of the following things can happen:

1. The real estate is sold by the LLC partnership, and the proceeds will be distributed to Fred, Bill and Jill, and all parties will be taxed. Although this is acceptable to Jill, Fred and Bill now find themselves with less money to invest in a new property.
2. The property is exchanged through 1031 exchanges, and the abandoned property is exchanged for a new one. No cash was received as all equity was invested in the acquisition of the new property and therefore no taxes were assessed. Although it’s OK for Fred and Bill, Jill still hasn’t cashed in.

Drop and Swap

Drop and Swap exchanges fill this need.

A drop and trade allows Jill to transfer her membership interest to the LLC (Fred and Bill) and receive a percentage equity interest in the property equal to her forfeited membership interest.

This “drops” ownership of the real estate from “entity level” to Common Interest Lease (TIC) between an LLC (Fred and Bill) and Jill. When the property is finally sold, the co-owners will be awarded the proceeds on a pro rata basis. Jill would receive money from the title company and pay taxes, and the LLC (Fred and Bill) could transfer its proceeds to the Qualified Intermediary and exchange it for new property, deferring taxation.

However, it should also be noted that standard 1031 transaction rules and timelines apply to an LLC seeking to effect a like-kind exchange.

A third potential scenario would dictate that Fred and Bill, as partners in an LLC, and Jill want to go into different properties. Then a more complicated reverse version of drop and swap is used, called “swap and drop” – however, they are rarely used.

Drop and Swap Holding Timing

It would be wise to seek tax and legal advice on the time between the restructuring of the ICT entity (tenants in common) and a subsequent sale and exchange. The IRS can prohibit the exchange if the drop and exchange were made just before the sale, and there is no clear rule in the tax code about how long before a sale the drop and the exchange can be made.

This is where an investor should rely on the advice of a qualified CPA who has experience with 1031 trading and the dip and trade strategy.

Can you do a 1031 trade after the close?

Usually you can’t do this because 1031s require Qualified Intermediaries (QI). However, you can cancel the transaction within the same tax reporting period and contact the buyer to agree to cancel the transaction. When the transaction is reversed, the IRS will treat the sale as if it never took place; the taxpayer recovers the buyer’s property, and the buyer receives all of the taxpayer’s purchase funds.

You can then file a 1031 exchange request and repeat the sale. Cancellation has long been recognized in law for transactions other than 1031 exchanges. The Internal Revenue Service, on the other hand, has allowed cancellation to be used to correct an error in a foreign exchange transaction.

This should not be confused with a reverse swap. A reverse exchange means the reverse of a conventional delayed 1031 exchange: instead of selling your old property and then buying a new property, you first buy your replacement property and then sell your old property.

The reverse 1031 exchange works for investors who have a great opportunity to buy and need to act quickly to secure the property.

Key points to remember

Deposit and exchange structures are useful for dissolving partnerships, when the parties want to separate, withdraw money or simply invest in different properties.

Be sure to speak to your CPA and attorney about this strategy well before attempting to restructure your entity and sell your property to ensure you are in compliance with IRS 1031 Exchange rules and regulations.

Chief Investment Strategist, Provident Wealth Advisors

Daniel Goodwin is Chief Investment Strategist and Founder of Provident Wealth Advisors, Goodwin Financial Group and Provident1031.com, a division of Provident Wealth. Daniel holds a Series 65 Securities license as well as a Texas Insurance license. Daniel is a representative investment advisor and trustee for corporate clients. Daniel has been serving families and small business owners in his community for over 25 years.

Securities offered by AAG Capital Inc., member SIPC and FINRA.

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