Drop and Swap Transactions

It is common in a transaction that title to a property is held by entity made up of multiple owners, but upon the sale of that property, some of the owners want to do a 1031 Exchange while the others want to cash out.How can the parties that want to exchange move forward?

Section 1031 has a few specific requirements that come up in these situations:

The taxpayer must be selling and purchasing real property held for productive use in a trade or business or for investment, and
The same taxpayer that relinquishes property must acquire the replacement property.

To meet the first requirement, a taxpayer must be on title to the property. If the taxpayer is a member of an entity, like an LLC or a partnership, then that taxpayer does not technically own property. They are a member of an entity that owns property.In most cases, that membership interest in the entity is not an exchangeable asset (Delaware Statutory Trusts being the most common exception).

The taxpayer can work with their tax professional or legal counsel to deed their interest from the LLC so that they are on title for their specific ownership of the property. For example, if there are 3 members of an entity and they all own 33.3% interest of the entity, but only one of them wants to do an exchange, they may be advised to drop their 33.3% interest out of the entity to themselves. Now, the taxpayer holds title to the property and can do an exchange with their interest in the real property.

Unfortunately, there are not established timeframes on how long before the sale this Drop and Swap can be done. Many tax professionals will recommend that the drop out of the entity one year in advance of the closing. But in many cases that is not feasible.

The California Franchise Tax Board (FTB) has been aggressively pursuing Drop and Swaps. They have taken the position that sale should be attributed to the entity selling, not the members, and have disallowed transactions. Their reasoning behind their position is if the entity negotiates the sale, signs the purchase agreement and other closing documents, then they are the seller, even if the deed is amended before closing (see California Board of Equalization v. Giurbino, Cal. St. Bd. Of Equal., Case No. 861813).

The Drop and Swap is a wonderful tool for taxpayers in certain situations. For more information, please reach out to your tax professional or legal advisor for specific questions or contact the specialists here at Security 1st Exchange for assistance.