To Drop and Swap or Swap and Drop?

That is the question.

We probably answer at least one phone call or email every day regarding how members of a partnership, limited liability company or other form of partnership who want to sell a property and go their separate ways may do so and still use a 1031 exchange. Typically, we find out about the issue when the closing of the sale of the property owned by the partnership is looming on the near horizon. In this situation, the distribution out of the partnership to the partners of pro-rata tenancy in common interests is not advisable.

The issue is largely due to the fact that there is no clear test of what is an acceptable “drop and swap” 1031 exchange holding period. When partners consider a drop from their partnership interest into a tenancy in common interest in the relinquished property and then swap or exchange out of the property, there is a danger if the “drop” takes place shortly before the closing, the IRS could disallow the exchanges into replacement properties. The IRS has reasoned that the tenancy in common interests in the relinquished property were not “held” long enough as investment or business use property, which is an essential requirement for the exchange.

The conventional wisdom— and in most cases, the safest approach—is to have the partnership proceed to closing of the old property and have Accruit, as the Qualified Intermediary, receive the exchange value per the 1031 Tax A 1031 exchange conducted under the safe harbor 1991 Treasury Regulations wherein the replacement property is received up to 180 days after the disposition of the relinquished property. Typically what people mean when referring to a 1031 exchange, Starker exchange, like-kind exchange, delayed exchange, etc. Deferred Exchange agreement. After the closing of the relinquished property, the partners will identify replacement properties which may be different types, i.e. multi-family residential, commercial/warehouse or any other property that is investment or business use property. Accruit will then acquire the various replacement properties on behalf of the partnership/taxpayer. The partners then agree to a special allocation within the partnership to track the profits and losses for the properties and allocate them to the rearranged partner groups during the subsequent holding period. After the partnership has held the properties in that arrangement for at least a couple of years, it will then distribute the property to the partners as tenants in common or to the new partner groups as new partnerships.

Keep in mind, there are still some adventurous souls who engage in drop and swap transactions involving short holding periods after the redemption of the partnership interests in return for the tenancy in common interests that are exchanged. They have relied on a long line of taxpayer-friendly federal cases such as Magneson v. Commissioner, 753 F.2d 1490 (9th Cir. 1985). Practitioners have repeatedly asked the IRS to soften its position regarding the requisite holding period and the step transaction doctrine, but the IRS has refused to do so. This continued attitude toward drop and swap situations does not provide much comfort to taxpayers or their professionals.

The California Franchise Tax Board (FTB) is an example of a state agency that has taken an even more aggressive position on the drop and swap issue by disallowing them and those decisions have generally been upheld. However, the FTB recently lost on appeal when the taxpayer-appellant’s attorneys successfully argued that not only did the timing of the TIC transfers not matter, but the FTB’s assertion that these pre-exchange transfers “lacked substance” was without merit. Take a look at the case entitled In the Matter of the Appeal of Sharon Mitchell (OTA Case No. 18011715) (January 18, 2020). Admittedly, when looking at these transactions either through the lens of Federal or state law and none of the partners are cashing out but doing exchanges, albeit into different property , the continuity of investment argument should be persuasive.

The answer to the opening question, unfortunately, is there is no clear test for the period of qualified use prior to a sale and exchange. It’s always important for anyone stuck in a partnership and contemplating an exchange with partners of diverging interests to talk to their tax advisors as soon as possible to avoid the pitfalls outlined above.