When Partners Want Different Outcomes: Planning a “Drop-and-Swap” 1031 Exchange
Real estate partnerships do not always end with every partner wanting the same thing. When a property is sold, one partner may want cash, another may want to purchase a separate replacement property, and others may want to continue investing together.
A properly planned “drop-and-swap” may allow the owners to pursue different objectives. However, these transactions require advance planning, especially in California. The ownership change should be completed as early as commercially practical, preferably before the property is listed for sale or material negotiations with a buyer begin.
For purposes of this article, references to “partners” include members of an LLC taxed as a partnership.
The Same-Taxpayer Requirement
A fundamental Section 1031 principle is that the taxpayer transferring the relinquished property must generally be the taxpayer acquiring the replacement property.
If an LLC taxed as a partnership owns a building, the LLC, not its individual members, owns the real estate for federal tax purposes. The members cannot simply direct their respective shares of the LLC’s sale proceeds into separate exchange accounts. They also cannot exchange their LLC membership interests because partnership interests are not eligible Section 1031 property.
If the owners want to complete separate exchanges, the ownership of the real estate ordinarily must be changed before the sale. In a typical drop-and-swap, the partnership distributes undivided interests in the property to some or all of its partners. The recipients then own direct tenancy-in-common, or TIC, interests that they may separately sell, exchange or cash out.
The ownership structure should reflect the partners’ actual objectives. It is not always necessary to distribute the entire property. For example, if two partners want to remain together and a third wants to separate, the partnership might retain a two-thirds interest while distributing a one-third TIC interest to the departing partner. The partnership and the departing partner can then separately decide whether to exchange or receive cash.
The Qualified-Use Requirement
Section 1031 applies only to real property held for investment or productive use in a trade or business. This is commonly called the qualified-use requirement.
The tax law does not provide a universal minimum holding period for property received in a partnership distribution. There is no automatic one-year or two-year safe harbor applicable to every drop-and-swap. Nevertheless, timing remains important because it is evidence of the owner’s intent.
A distribution made shortly before closing, after the partnership negotiated the sale, may attract greater scrutiny. A distribution completed before the property is listed or material sale terms are negotiated generally presents a stronger factual position. The new TIC owners have a better opportunity to function as genuine owners, participate in the sale process and bear the benefits and risks associated with their interests.
Simply waiting a predetermined number of months does not cure an otherwise artificial transaction. The ownership and conduct during that period must be real.
Start Planning Early
The partners should discuss their separate objectives before marketing the property whenever possible. Waiting until escrow is about to close limits the available choices and may require amendments, buyer consent, lender approval or rushed entity work.
Before proceeding, the owners and their advisors should determine:
- Which partners want cash;
- Which partners want separate exchanges;
- Which partners want to remain invested together;
- Whether the partnership agreement permits in-kind property distributions;
- Whether the property has debt that must be allocated or replaced;
- Whether the buyer and lender will accept the ownership change; and
- How expenses, deposits, liabilities and sale proceeds will be divided.
The partnership’s tax attorney and CPA should review the proposed distribution, the partners’ capital accounts and the tax consequences before any deed is recorded.
Treat the TIC Owners as the Actual Owners
A deed should not be the only evidence that ownership changed. The transaction documents and the parties’ conduct should consistently recognize the TIC owners.
Depending on the timing and circumstances, the following practical steps should be considered:
- Record the deed transferring the TIC interests.
- Amend or terminate the partnership documents as appropriate.
- Identify the TIC owners correctly in the purchase agreement, amendments and escrow instructions.
- Obtain the buyer’s written acknowledgment of any assignment or change in sellers.
- Have each TIC owner sign the relevant sale and closing documents in the proper capacity.
- Allocate expenses, liabilities, deposits and proceeds according to the ownership interests.
- Have each owner enter into a separate qualified-intermediary agreement before transferring that owner’s interest.
- Send each owner’s exchange proceeds directly from escrow to that owner’s qualified intermediary.
- Report the distribution, sale and exchanges consistently on the partnership and individual tax returns.
Documents should not describe the partnership as the sole seller while the tax returns treat the partners as the sellers. The purchase agreement, deeds, escrow instructions, settlement statements, exchange documents and tax reporting should tell the same story.
Should the Owners Have a TIC Agreement?
Generally, yes. A written TIC agreement is advisable when the owners will hold the property together for a meaningful period. It can establish:
- Each owner’s percentage interest;
- Responsibility for property expenses and liabilities;
- Rights to income and sale proceeds;
- Insurance obligations;
- Procedures for approving leases, improvements or a future sale;
- Responsibility for property management; and
- Procedures if an owner dies, defaults or wants to transfer an interest.
The agreement must be drafted carefully. If the arrangement has too many partnership-like features—such as centralized business operations, disproportionate sharing of profits and expenses, or excessive restrictions on an owner’s rights—the arrangement could be treated as a tax partnership instead of direct ownership of real estate.
If the TIC ownership will exist only briefly before an already-planned closing, a lengthy operating agreement may be unnecessary. A shorter agreement can confirm the ownership percentages, allocation of expenses and proceeds, closing authority and the absence of a partnership relationship. Even a streamlined agreement should be prepared or approved by the owners’ legal and tax advisors.
For a longer holding period, the agreement should be more comprehensive, and the owners should actually operate consistently with it. Rental income, expenses, insurance, accounting and tax reporting should reflect their direct ownership.
Consider the Alternatives
A drop-and-swap is not the only possibility. If the exchanging partners want to remain together, the partnership may complete the exchange while cashing out another partner through a carefully structured redemption or special allocation. Alternatively, the partnership may acquire replacement property and distribute it later.
These alternatives can create their own capital-account, debt-allocation, financing and ownership issues. They should not be assumed to be safer merely because the partnership remains the exchanger.
The Practical Takeaway
The best drop-and-swap planning is usually straightforward:
- Identify the partners’ different goals early.
- Restructure ownership before marketing or negotiating the sale whenever possible.
- Make the TIC ownership genuine, not merely documentary.
- Use a properly tailored TIC agreement.
- Keep the sale documents, exchange documents and tax reporting consistent.
- Have the structure reviewed by the owners’ tax attorney and CPA before implementation.
There is no document or prescribed holding period that guarantees a successful result. The strongest transactions are those in which the legal ownership, economic conduct and reported tax treatment all match.
This article provides general educational information and is not tax or legal advice. Section 1031 transactions involving partnerships, property distributions, TIC interests, special allocations or ownership changes require advice from the taxpayer’s independent tax and legal advisors. Peak 1031 Exchange, Inc. serves as a qualified intermediary and does not determine whether a transaction qualifies for tax-deferral treatment.
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