Often times when a partnership or LLC is selling a real estate investment, some partners may be ready to cash out, while others would like to defer the gain and reinvest in real estate. If the partnership simply sells the property and uses part of the proceeds for a like- kind exchange under Section 1031 and distributes the remaining proceeds to the cash out partners, the gain on the sale that was not reinvested would be taxable to all of the partners (not just the partners receiving the cash). This obviously is undesirable to those partners who wish to defer their gain.
What if the partnership liquidated and transferred title to all of the partners individually in anticipation of the sale and then each partner sold or exchanged as desired? The problem with this approach is that the person who engages in a 1031 exchange must have held the property for investment. The IRS has challenged transactions in which someone has acquired an interest in property and immediately engaged it in a like kind exchange. The IRS argues that the person acquired the property not for investment purposes but for the sole purpose of selling it and therefore does not qualify.
In order to address the desires of both groups of partners, a partnership could engage in what is commonly referred to as a “drop and swap” transaction. In this transaction, the partnership distributes a fractional interest in the real estate to those partners who want to cash out. These fractional interests are generally tenancy in common interests, known as TICs.
At the time of sale, the buyer will acquire ownership of the property from multiple sellers (i.e. the partnership and the partners holding the TIC interests). The partners receive their cash and the partnership (as the historical owner of the property) can use its portion of the sale proceeds to engage in a Section 1031 like-kind exchange.
Bottom Line: A drop and swap transaction can be a great way to meet the desires of partners in a real estate partnership who have different goals and tax sensitivities.
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