Section 1031 Understanding Drop & Swap

Each month we receive calls from investors who won­der how the same tax­pay­er rules apply to §1031 tax deferred exchanges involv­ing mul­ti­ple own­ers. There are spe­cif­ic rules that need to be fol­lowed so the exchange is not con­sid­ered invalid (by the IRS). 

July 6, 2024

By Al DiNi­co­la, AIF®, CEPA™
DST 1031 Spe­cial­ist
NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC
Secu­ri­ties offered through MSC-BD, LLC Mem­ber of FINRA/SIPC

A  failed exchange will result in the defer­ral of cap­i­tal gains (one of the major advan­tages of the §1031) being not rec­og­nized. This would result in cap­i­tal gains tax­es as well as depre­ci­a­tion recap­ture to be imme­di­ate­ly due. In addi­tion, any debt paid off from the sale of the prop­er­ty may also trig­ger addi­tion­al tax­es due from cal­cu­la­tion of mort­gage boot.

For over one hun­dred years the pro­vi­sion of Sec­tion 1031 of the Inter­nal Rev­enue Code has been used suc­cess­ful­ly by many investors in a vari­ety of sit­u­a­tions. Over the years the per­mit­ted exchanges have includ­ed oth­er assets besides real estate. Since the ini­ti­a­tion of the Tax Cuts and Jobs Act of 2017 only real estate is per­mit­ted for tax deferred exchanges.  Sim­ply put cap­i­tal gains are deferred (not elim­i­nat­ed) if the investor fol­lows all the require­ments of the exchange. The defer­ral would include the cap­i­tal gains as well as the recap­ture of depre­ci­a­tion on the prop­er­ty dur­ing own­er­ship.   In gen­er­al terms the prop­er­ties involved need to be like kind and all the pro­ceeds need to be rein­vent­ed.

Same Tax­pay­er rule:

Adher­ing to all the rules of §1031 is the most impor­tant ele­ment. If any of the rules are not fol­lowed there is a risk of the 1031 being jeop­ar­dized.  The same tax­pay­er rule may be over­looked and mis­un­der­stood.  We fre­quent­ly receive calls from investors attempt­ing to under­stand what the same tax­pay­er real­ly means and how cur­rent own­er­ship inter­ests are held. The tax­pay­er enti­ty that holds the relin­quished prop­er­ty must be the same as the tax­pay­er acquir­ing the replace­ment prop­er­ty.  If the sell­er is an indi­vid­ual tax­pay­er (i.e. using a per­son­al social secu­ri­ty num­ber or EIN) there nor­mal­ly is an easy tran­si­tion to the replace­ment prop­er­ty using the same tax­pay­er id.  What becomes some­what chal­leng­ing is if the prop­er­ty is held in an LLC, part­ner­ship of oth­er own­er­ship struc­tures.

Own­ers in agree­ment

If all the own­ers with­in what­ev­er struc­ture agree to move for­ward with a §1031 the enti­ty may stay intact when sell­ing the prop­er­ty and acquir­ing the replace­ment prop­er­ty.  There may be oth­er exit strate­gies post exchange pro­vid­ing poten­tial liq­uid­i­ty to mul­ti­ple investors.

Part­ner­ships Prob­lems

There are a few lev­els of con­cerns and com­plex­i­ty when a part­ner­ship wants to enter­tain enter­ing into a §1031 exchange.  Not all part­ner­ships last for­ev­er and may not even stay togeth­er for the ini­tial hold­ing peri­od. So, what hap­pens when the part­ner­ship wants to unwind.  If the prop­er­ty is sold one part­ner may want to exe­cute a §1031 and oth­er part­ners may want to sim­ply pay their cap­i­tal gains and take the pro­ceeds.  There may be added stress, con­fu­sion, and poten­tial­ly pan­ic among and between the part­ner investors. Basi­cal­ly, the part­ner­ship (tax­pay­er) that sells (exchanges) the prop­er­ty must be the same enti­ty or buy­er that acquires the replace­ment prop­er­ty.  The part­ners are not per­mit­ted to sep­a­rate, now what?  

Fun­ny sound­ing Solu­tion “Drop and Swap”

Two words “Drop and Swap” requires two steps or phas­es. This is used with §1031 exchange to address and solve the prob­lem when part­ners are not in agree­ment with the future plans for invest­ment real estate. Tim­ing is key in the exe­cu­tion of the Drop and Swap.

Step One- The DROP. The part­ners need to be in agree­ment on the process. Pri­or to the sale the part­ner­ship needs to be elim­i­nat­ed or dis­solved or liq­ui­dat­ed and moved to a dif­fer­ent own­er­ship struc­ture. In many cas­es prop­er­ties may be owned by part­ner­ships or LLCs.  The replace­ment own­er­ship struc­ture most pre­ferred is a ten­ant in com­mon (TIC). Think of it as a dis­tri­b­u­tion of the prop­er­ty to each of the indi­vid­ual part­ners or mem­bers. The per­cent­age of own­er­ship inter­est can be defined so that each part­ner now a TIC mem­ber will have their share of own­er­ship to deter­mine what to do with their pro­ceeds. We have also seen a dis­tri­b­u­tion of the debt that is asso­ci­at­ed with the real estate.

Step Two-Exe­cut­ing the Swap: Under the struc­ture of the TIC each investor/owner may decide what to do with their respec­tive own­er­ship in the real estate. Each investor will hold direct title to their per­cent­age or por­tion of the real estate inter­est. This enables each own­er to decide to par­tic­i­pate in their own designed exit strat­e­gy.  Once each investor is con­sid­ered a sep­a­rate sell­er (enti­ty) each can exchange for anoth­er prop­er­ty via §1031 or take the cash and pay their cap­i­tal gains.

What are the Risks:

There may be sev­er­al risks of con­sid­er­a­tions that Investors should  be ful­ly aware.

1. Plan­ning- the tim­ing of the drop becomes the main issue.  The IRS (while there is no offi­cial time­line) may view the drop and swap strat­e­gy may be dis­qual­i­fied if the steps hap­pen too close togeth­er and espe­cial­ly too close to the sale of the prop­er­ty.
2. The Paper trail- All investors need to be aware that the dev­il may be in the details, and every­thing needs to be doc­u­ment­ed in the change in the own­er­ship struc­ture. Even if the ulti­mate goal is to exe­cute an exchange doc­u­ments mat­ter.
3. Get the right advice- the legal and tax advo­cates for each investor need to be involved. There are many com­plex issues with the drop and swap strat­e­gy and all investors need to seek assis­tance.
4. IRS eyes- Not all exchanges may be reviewed by the IRS. If the IRS believes there are tax avoid­ance strate­gies (schemes) investors may find their plans dis­al­lowed and the exchange will be dis­al­lowed.

Exit Options the DST and Part­ner­ships

Over the years investors who seek their own path via 1031 exchange the Delaware Statu­to­ry Trust (DST) has been an accept­able and pre­ferred invest­ment.  Investors seek­ing pas­sive man­age­ment and pas­sive income appre­ci­ate the advan­tages of the DST.

Because investor sit­u­a­tions and objec­tives vary this infor­ma­tion is not intend­ed to indi­cate that an invest­ment is appro­pri­ate for or is being rec­om­mend­ed to any indi­vid­ual investor.

Thank you.

This is for infor­ma­tion­al pur­pos­es only, does not con­sti­tute indi­vid­ual invest­ment advice, and should not be relied upon as tax or legal advice. Please con­sult the appro­pri­ate pro­fes­sion­al regard­ing your indi­vid­ual circumstance(s).

DSTs are not for all investors. The acqui­si­tion of a DST is for accred­it­ed investors only. Con­tact your invest­ment advis­er for addi­tion­al details on how a DST may be a solu­tion to your 1031 Exchange and suit­ed for your invest­ment future. For more infor­ma­tion on how to prop­er­ly set up an IRC §1031Tax Deferred Exchange or if you are an accred­it­ed investor and would like addi­tion­al infor­ma­tion on a DST con­tact Al DiNi­co­la at 239–691-8098 or email adinicola@namcoa.com.This is not an offer to pur­chase or solic­i­ta­tion to pur­chase any secu­ri­ty, as such be made only through an offer­ing mem­o­ran­dum or prospec­tus. Invest­ing in secu­ri­ties, real estate, or any invest­ment, whether pub­lic or pri­vate, involves risk, includ­ing but not lim­it­ed to the poten­tial of los­ing some or all of your invest­ment dol­lars when you invest in secu­ri­ties. You should review any planned finan­cial trans­ac­tions that may have tax or legal impli­ca­tions with your per­son­al tax or legal advi­sor. NAMCOA, LLC is a Reg­is­tered Invest­ment Advi­sor, reg­u­lat­ed by SEC (Secu­ri­ties and Exchange Com­mis­sion).

Our cor­po­rate office is locat­ed at 999 Van­der­bilt Beach Road, Suite 200, Naples Flori­da 34108. Secu­ri­ties Offered through MSC-BD, LLC, Mem­ber of FINRA/SIPC. 8215 SW Tualatin-Sher­wood Rd, Suite 200 Tualatin, OR 97062.  MSC-BD, LLC and NAMCOA are inde­pen­dent­ly owned and are not affil­i­at­ed.