Drop Then Swap: 1031 Exchanges

Haislet_ScottInternal Revenue Code (IRC) §1031 exchanges permit a seller of investment or business property to reinvest into “like kind” replacement property to avoid (defer) taxable gain.

Scenario 1: Individuals A and B own XYZ LLC (treated like a partnership for federal tax purposes). XYZ owns investment realty and wants to sell it. A and B want to reinvest in replacement investment realty, but not together. A and B want to do separate §1031 exchanges. The real estate agent says they can do it, that it’s done all the time.

Can they? No.

A and B each own a share of a partnership (the LLC), which is not eligible for IRC §1031 treatment.[1]

Scenario 2: Individuals A and B own investment realty as tenants in common (a TIC). A and B seek to sell the realty. A and B want to reinvest in real estate, but not together. A and B want to do separate 1031 exchanges.

Can they? Yes (well, maybe).

IRC §1031(a)(2) provides: “… an interest in a partnership which has in effect a valid election under IRC §761(a) to be excluded from the application of all of subchapter K (of the IRC) shall be treated as an interest in each of the assets of such partnership and not as an interest in a partnership.”

Thus, A and B treat their respective TIC interests as direct fractional ownership of the realty, such interests are eligible for IRC §1031 treatment.[2]

So, how does the LLC in Scenario 1 above “convert” to TIC status found in Scenario 2?

§761(a) Election

IRC §761(a) provides an election for certain partnerships to avoid partnership tax rules. To gain §761(a) status, a partnership must make and qualify for the election.

Making the §761 Election

A partnership may make the election by filing a simple form with the IRS no later than the due date for the partnership’s tax return for the year the election is to begin.

A partnership in its first year of operation may obtain a “deemed” election if: (1) the partners agree (presumably in writing) to elect §761(a) status, or (2) the partners report their separate respective shares of income, deductions, etc., on their respective tax returns from the first year.

Qualifying for the §761 Election

Just making the election is insufficient. A partnership seeking IRC §761(a) status must qualify for it. Not all partnerships qualify. Not eligible are those partnerships:

  • With special allocations of income or gain (e.g., a developer’s carried interest) or disproportionate allocations of debt and equity.
  • With different classes of members.
  • Organized as an LLC.
  • Imposing restraints on alienation of a partnership interest (though a right of first offer is not considered a restraint generally).
  • With active business in contravention of IRC §761(a)(1).[3]

For more information about qualifying for IRC §761(a) election, see Reg. §1.761-2 and IRS Revenue Procedure 2002-22 (not substantive law).

Drop Then Swap

Feature_5Under Scenario 1, A and B (as members of XYZ LLC) seek a valid IRC §761(a) election.
As a practical matter, the realty must be distributed from the LLC to A and B as TIC owners (sometimes this is accomplished with dissolution of LLC, but that is not necessary, particularly if the LLC has other properties). That’s called the “drop.”

After such distribution, A and B take their proceeds separately and implement separate 1031 exchanges. That’s called the “swap.”

Does This Qualify for §1031 Treatment?

The Bolker case[4] does not address drop then swap expressly. Rather, Bolker eliminates any holding period that IRS says is required to form intent with respect to exchanging property under §1031. Thus, taxpayer argues that a TIC interest under a §761(a) election is §1031-eligible, even though such interest was created very recently.

To the contrary, the government may view the distribution as having no purpose other than to avoid 1031-ineligibility under IRC §1031(a)(2)(D), and deny §1031 treatment.

The government may argue that each distributee did not sufficiently “hold” their investment as required by IRC §1031(a)(1) (property must be “held for” business or investment to qualify for §1031 treatment). The government says insufficient time between the drop and the swap will deny §1031 treatment, notwithstanding Bolker.[5]

In addition, IRS Form 1065 (partnership income tax return) asks whether the LLC distributed property in current or prior year—certainly a flag.

LLCs should consider this question early. A drop on Tuesday followed by a swap on Thursday looks weak contrasted with a drop that occurred two years before the swap (though Bolker discarded the time element in granting §1031 treatment).

Also, LLCs that dissolve and adopt TICs should consider other reasons for making the change (to create a “business purpose”). Notwithstanding how late a drop then swap occurs, an independent reason for doing it might override government objections.

Consider side effects, e.g., will a drop trigger a loan default?

Consider an alternative: Swap then drop. That is, the LLC implements the §1031 exchange, buys replacement properties for each of the members, then makes special allocations of each property to one or more members.
Drop and swap can work, but all factors must be considered.

G. Scott Haislet is a Lafayette CPA and attorney (certified specialist in tax) with a particular emphasis on 1031 exchanges and real estate. Contact him at (925) 283-1031 or scott@goscott.com.

Copyright 2014, G. Scott Haislet (no copyright claimed on government works). This work may be republished or distributed without permission only in its entirety. All other use prohibited absent permission. This is not legal, tax, or accounting advice or counsel. Please consult a qualified adviser for specific representation or counsel.

[1] IRC §1031(a)(2)(D).
[2] This does NOT say a partnership is not eligible; LLCs and partnerships as entities may use 1031 without concern of IRC §1031(a)(2)(D).
[3] For example, a hotel is an active business; even if a TIC owned the hotel, it still does not qualify for IRC §761(a) election; see IRS Revenue Ruling 75-374 for an example of a qualifying apartment investment.
[4] Bolker v. Comm’r, 760 F.2d 1039 (9th Cir. 1985).
[5] See IRS Revenue Ruling 77-337 for the two-year “holding period” rule.

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