Case Study: Drop & Swap for One Member to Cash-Out and 2nd Member to 1031 Exchange

Much has been written about the Same Taxpayer rule and about Drop and Swap transactions. But what happens when one of the partners wishes to cash out upon sale and the other wishes to continue investing?

The Situation

Ross and Joey have been friends their entire lives. After college they decided to pool some cash and buy investment real estate. Rather than consulting an attorney or CPA, they bought books, attended seminars, and talked to friends about their plans. As a result, they went online and formed Unagi LLC, and a short time later acquired their first rental property – a duplex in Bethlehem, PA – for $310,000. During the thirty years that they owned the property, it has been well maintained, and has generated significant cash flow for the friends. Joey has decided that he no longer wants to own this property, he wants to enjoy the use of his share of the sale proceeds and retire to Southern California; however, Ross wants to continue investing in real estate. Their friend, Gunther, is a real estate agent, and has told them that they can sell the property for about $1,600,000.

The Problem

Ross recognizes that the sale of the property would result in capital gains tax on $1,290,000 ($1,600,000 minus $310,000), plus depreciation recapture tax on $310,000. Their tax on the gain would be about $258,000, plus an additional $85,000 in depreciation recapture tax, plus state taxes (3.07% tax rate of PA) of roughly $39,603, and net investment income tax of $49,020 at a rate of 3.8%. Their $1,290,000 profit would be reduced by at least $431,623 due to associated taxes. Ross isn’t willing to incur this taxable event.

The Solution

Ross and Joey consult their tax and legal advisors, and structure a variation of the “drop and swap” strategy in that Joey will withdraw from the LLC under state laws. In exchange for his 50% interest in Unagi LLC, he will become a 50% tenant in common owner of the property, owning alongside Unagi LLC. Simultaneous with Joey’s withdrawal from the LLC, Ross’s sister Monica will become a 1% member of Unagi LLC, allowing its status as a tax partnership to remain intact because Unagi LLC continues to have multiple members, notwithstanding the change of members. At the end of the year, Unagi LLC’s CPA will issue appropriate documents so that Joey will recognize his fair share of the depreciation recapture and capital gains. The result to Joey should effectively be no different than it would have been if he stayed in the LLC and the property was simply sold without an exchange.

At the time of the sale of the Bethlehem duplex, Joey will receive his 50% share of the proceeds in a taxable event to him. Ross has consulted with additional tax and legal advisors, and Unagi LLC will enlist the aid of a Qualified A person acting to facilitate an exchange under section 1031 and the regulations. This person may not be the taxpayer or a disqualified person. Section 1.1031(k)-1(g)(4)(iii) requires that, for an intermediary to be a qualified intermediary, the intermediary must enter into a written "exchange" agreement with the taxpayer and, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer. Intermediary (“QI”) such as Accruit to help structure its portion of the transaction as a 1031 exchange, allowing him to defer the associated taxes. The QI will work with the other professionals involved in the transaction, preparing the necessary exchange documents, and holding Unagi’s share of the sale proceeds. Within 45 days after the sale, Unagi LLC will identify appropriate replacement properties. Learn more about the Rules for Identification and Receipt of Replacement Property in a 1031 exchange. Using the exchange proceeds held by the QI, Unagi will complete the acquisition of a new property, Those certain items of real and/or personal property qualifying as “replacement property” within the meaning of Treasury Regulations Section 1.1031(k)‑1(a) and either: (a) received by the taxpayer within the designation period in accordance with Treasury Regulations Section 1.1031(k)‑1(c)(1) or (b) identified in a written designation notice signed by the taxpayer and hand delivered, mailed, telecopied or otherwise sent to the qualified intermediary before the end of the designation period in accordance with Treasury Regulations Sections 1.1031(k)‑1(b) and (c). The definition of “replacement property” shall not include property the identification of which has been revoked by the taxpayer in accordance with Treasury Regulations Section 1.1031(k)‑1(c)(6); (“New Asset”) Property or properties properly received by a taxpayer as part of a 1031 exchange. Replacement Property , worth at least $800,000, thereby exchanging equal or up, and maximizing the value of their 1031 exchange.

The Result

Joey was able to cash out of the original investment property, pay associated taxes, and retire to Southern California, where he is now pursuing an acting career. Ross and Monica, as the two members of Unagi LLC, continue to own investment property in the Bethlehem area. Ross deferred the taxes from the sale of the original investment property by utilizing a Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange . Those taxes will remain deferred until Ross completes a real estate transaction, if ever, without the use of a Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange .

As always, taxpayers are encouraged to discuss their plans with their tax and legal advisors before they embark on the path toward the sale of an investment or business use property, and to engage the services of a Qualified A person acting to facilitate an exchange under section 1031 and the regulations. This person may not be the taxpayer or a disqualified person. Section 1.1031(k)-1(g)(4)(iii) requires that, for an intermediary to be a qualified intermediary, the intermediary must enter into a written "exchange" agreement with the taxpayer and, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer. Intermediary the first closing that will be part of their exchange.