It is common for investment real property to be owned by co-owners. Many of these co-ownership arrangements are partnerships for tax purposes, sometimes even if the co-owners do not realize it.
While the tax partnership may be structured as a general partnership, for liability protection purposes, as well as centralized management, many real property co-ownership arrangements are structured as a limited partnership (“LP”) or as a multi-member limited liability company (“LLC”).
For various reasons, there may come a time that the partners desire to disassociate, i.e., “split up.” In that instance, the partners may desire to dispose of the real property without recognition of taxable gain under Internal Revenue Code (“Code”) §1031. Under Code §1031, a taxpayer can exchange real property used in a trade or business or held for investment for other like-kind real property. The property disposed of is often called the ”relinquished property” while the like-kind property acquired is called the “replacement property.”
For purposes of Code §1031, the partners cannot simply exchange their partnership interests for another partnership interest or an interest in real property. Such exchanges do not qualify for non-recognition treatment as a partnership interest is not considered “like kind” with real property or with another partnership interest. Instead, the partners must structure the transaction as an exchange of interests in real property, which qualifies as “like kind” property under Code §1031, permitting the nonrecognition of taxable gain.
Two common ways to accomplish a partnership split-up via a Code §1031 exchange are (1) the “drop and swap” and (2) the “swap and drop.”
Drop and Swap
In a “drop and swap,” the partnership distributes the real property to the partners pro rata as tenants-in-common prior to the exchange. Generally, this distribution will be tax-free under Code §731.
Following the “drop,” each co-tenant then exchanges his or her undivided interest in the property pursuant to Code §1031. This is the “swap” in the transaction. Alternatively, one co-tenant can engage in a Code §1031 exchange while the other co-tenant sells his or her undivided interest for cash in a taxable transaction.
The “drop and swap” is a popular way to structure a partnership split-up because of the flexibility it provides the partners. However, there are some common issues that should be considered before engaging in such a transaction:
- Often, the partners fail to plan ahead and there is too little time between the “drop” and the “swap.” For example, partners often wait until a purchase and sale agreement is signed before distributing the relinquished property, which results in increased risk of the IRS or California Franchise Tax Board (“FTB”) disallowing the exchange. In addition, even entering into a broker’s agreement for sale of the relinquished property prior to the drop should be avoided, as the property would not be treated as held for investment purposes.
- If the relinquished property is subject to a loan, lender approval should be obtained to distribute the property to the partners.
- If there are disputes among the partners, the partners may fail to cooperate with one another following the “drop” to sell the relinquished property.
Swap and Drop
In a “swap and drop,” the partnership sells the real property pursuant to a Code §1031 exchange (the “swap”) and then later distributes the replacement property (the “drop”) to the partners. Partners may prefer to engage in a “swap and drop” if they are concerned about the risk of a “drop and swap,” especially if a sale of the relinquished property is already in progress.
In acquiring replacement property in the exchange, each partner designates a separate replacement property to be acquired by the partnership. Following the acquisition of the replacement properties, the partnership continues in operation for some time.
After an appropriate amount of time has passed following the exchange evidencing that the replacement property is held for investment and not for distribution to the partners, the partnership then distributes the replacement properties to the respective partners as part of a tax-free partnership distribution pursuant to Code §731. In order to facilitate the “swap and drop,” the separate replacement properties are often acquired in the name of single-member LLCs wholly owned by the partnership, and the partner who is designated to eventually receive that LLC is often designated as the manager of the LLC.
Before engaging in a “swap and drop,” the partners should consider some important issues:
- Depending on the number of partners involved, it may be complex to carry out the exchange. For example, the more partners and replacement properties that must be acquired, the more coordination and planning will be required, including decisions regarding identification of replacement property, closing multiple acquisitions, and ensuring proper allocation of exchange proceeds among the acquisitions.
- The partners will need to decide how long the replacement properties should be held before being distributed. While there is no bright-line rule, generally the shorter the period of time, the greater the risk that the IRS or FTB may disallow the exchange.
The “drop and swap” and the “swap and drop” are two of the most popular ways for partnerships to engage in a Code §1031 exchange in connection with a partnership split-up. However, both transactions are complex and come with numerous nuanced issues. Consequently, the partnership and the partners should seek the advice of qualified tax and legal counsel so that the transactions are respected by the IRS and FTB.
Tim Boone is an associate in the Real Estate department at Berliner Cohen, LLP. He can be reached at firstname.lastname@example.org.
This article is not intended to and does not constitute legal advice or a solicitation for the formation of an attorney-client relationship. Anyone with questions about this topic should consult an attorney.
 See Rev. Proc. 2002-22 (2002), which provides guidelines for obtaining a private letter ruling from the IRS that co-ownership of real property is not a partnership for federal tax purposes.