Real estate investors are always looking for ways to increase profits, decrease tax burdens, and keep the overall structure of their portfolios flexible. One such strategy that has become increasingly popular in recent years is the 1031 exchange “drop and swap.” This strategy enables investors to postpone fulfilling capital gains tax obligations while simultaneously changing the ownership structures of their properties, which can be beneficial when fine-tuning investments.
In this article, we will explain a 1031 exchange, explain the “drop and swap” approach, and outline its importance for real estate investors. This strategy can help seasoned investors and novices alike make more strategic moves in their portfolios.
Starting with Basics of a 1031 Exchange
What a 1031 Exchange Entails and Its Goals
Real estate investors can defer capital gains taxes under a 1031 exchange, named after U.S. Internal Revenue Code Section 1031. The provision’s primary aim is to provide tax deferral incentives to encourage further investment in real estate. It enables investors to reinvest the proceeds from selling an investment property into another like-kind property.
1031 Benefits: Deferring Capital Gains Taxes
One of the primary advantages of a 1031 exchange is the ability to delay paying capital gains taxes. Without the exchange, investors would have to pay taxes on the profit earned from selling a property, significantly reducing the amount that could be reinvested. By delaying the payment of taxes, investors can use more capital to purchase higher-value properties or expand their portfolios.
Eligibility Requirements for Properties
A prerequisite to a 1031 exchange is that the properties involved have to be like-kind, which means that even if they differ in grade or quality, they are of a similar nature. For example, an apartment building can be exchanged for a commercial office space, or a vacant lot can be exchanged for a rental property. However, personal residences and those properties primarily held for sale do not qualify under this rule.
1031 Exchange Drop and Swap Overview
Defining 1031 Drop and Swap
A drop and swap strategy is a type of 1031 exchange that involves changing the property’s ownership before finalizing the exchange. ‘Drop’ refers to the change in property ownership, and swap refers to individual partners completing their 1031 exchanges and each reinvesting their share of the proceeds into new properties.
The “Drop”
In the “drop” stage, the owner’s structure of an asset, such as an LLC or partnership, is disbanded, and ownership interests are given out to the individual partners. This step is important because it ensures direct control by each partner over a share of the property and the subsequent exchange as well.
The “Swap”
After the ownership interests are allocated, each partner can now complete an individual 1031 exchange. Essentially, they can divest their portion of the asset and use the funds to purchase another similar asset while ignoring capital gains taxes.
Example Drop and Swap Scenario
Let’s look at an example. Three partners own a commercial property through an LLC. They agree to sell the property and move in different directions. They begin by dissolving the LLC so it can be split instead of selling it collectively. Thereafter, each partner can complete their own 1031 exchange by selling their individual shares and utilizing the funds to purchase properties that have the same plan as the partner.
Why Use The Drop And Swap Strategy?
Achieving Single Ownership of Property
The drop and swap strategy is particularly effective when partners wish to terminate their joint ownership and pursue individual investment options. After relinquishing joint ownership, each partner can invest in properties that meet their individual needs and goals.
Parting Ways
For various reasons, partners may wish to go their separate ways and pursue different investment opportunities. A drop and swap is one way to meet those goals.
Possibilities Of Another Property Investment
Accomplishing a 1031 exchange opens up endless opportunities for investors. This flexibility is crucial in fast-moving real estate markets, where investment directions can change suddenly.
Key Steps in A 1031 Drop And Swap
Divesting of Ownership
- Breaking Up With A Partnerships: The first step is to dissolve a legal entity on which the ownership model is based, be it an LLC or partnership. This involves legal paperwork and consent from all participants.
- Deeding Property Interests to Individual Partners: Immediately after the dissolution of the partnership, the remaining ownership interests are allocated to specific partners. This step will help to ensure all the partners have unencumbered title to their proportionate share of the property.
Swapping Through the Exchange
- Each Party Completes Their Own 1031 Exchange: After the ownership interests have been allocated, each partner may liquidate their interest in the partnership and use the cash received to acquire a replacement property. This step must be completed within the timelines the IRS mandates for 1031 exchanges.
Potential Risks and Challenges with Drop and Swap
IRS Scrutiny and Intent Issues
The IRS closely monitors whether 1031 exchanges have been made for valid investment reasons and not simply to shift the federal tax burden. Investors must prove their primary plan is to reinvest in similar properties instead of selling their assets for cash.
Timing Considerations
In a 1031 drop and swap exchange, the drop must occur well before the sale of the relinquished property. Doing it too close to the sale date can raise red flags with the IRS and potentially disqualify the exchange, as it can appear that the intent was to avoid taxes rather than actually invest in a replacement property.
Documentation and Legal Complexities
The legal and tax documentation required for the drop and swap is significant. Mistakes or omissions may result in penalties, delays, or disqualification from benefiting from the 1031 exchange.
Legal and Tax Issues with Drop and Swap
Strategic Intent to Invest
To avoid IRS queries, investors must properly demonstrate their intentions to reinvest in like-kind properties. This requires meticulous documentation of the transaction and hiring the right professionals.
Risk Mitigation Strategies
Investors can reduce risks by following IRS regulations, substantiating claims with appropriate documentation, and obtaining professional guidance familiar with drop and swaps throughout the process.
Seeking Professional Legal and Tax Advice
The drop and swap strategy poses some challenges, so legal guidance from qualified professionals specializing in 1031 exchanges will be needed.
Alternative Strategies
Swap and Drop
A “Swap and Drop” is basically the opposite of a “Drop and Swap.” Rather than first dissolving the partnership into individual ownership (“dropping”) and then performing the 1031 exchange (“swapping”), the partners do a traditional 1031 exchange together, and then the partner who wants to cash out would “drop” their ownership interest in the new property, allowing them to exit the investment and realize their gain.
Pros and Cons of Each Method
- Drop and Swap: This method gives the individual partners much more autonomy and control but requires meticulous attention to timing and documentation.
- Swap and Drop may streamline the process, but it also increases the risk of being disqualified by the IRS. It can look like a deliberate attempt to avoid taxes by manipulating ownership structures.
1031 Drop and Swap Example
Let’s imagine four partners own a multi-family property held in an LLC. They wish to sell the property and go into different investments. Using the drop and swap strategy, they liquidate the LLC, allocate ownership interests, and then, each partner does his or her 1031 exchange. One partner buys a commercial office building, another buys a rental property, and the other two buy vacant land for development in the future. All the partners were able to defer capital gains taxes and meet their investment objectives due to hiring the right people and following the proper steps.
Best Practices for Investors
Proper Planning and Legal Structuring
Investors should plan the drop and swap strategy for some time in the future and ensure that all legal and tax aspects are considered.
Documentation Tips
Keep all records of the transaction, partnership agreements, deeds, and exchange documents handy.
Working with Qualified Intermediaries and Experienced Legal Counsel
Hire professionals who specialize in 1031 exchanges so that they can facilitate the transactions and help mitigate the risks.
Real estate investors can greatly benefit from the drop-and-swap strategy by deferring capital gains taxes while changing ownership of a property. Investors can achieve their goals by following key steps, basic rules and eliminating potential risks. However, because of the complexity involved in this strategy, it is important to seek professional help from those who are experienced with drop and swaps. With proper organization and implementation, the drop-and-swap approach will greatly enhance an investor’s real estate resources.
An Elevated View
Here at Perch Wealth, we specialize in 1031 exchange replacement properties and Deleware Statutory Trusts (DSTs). Contact us today to learn more about how you can leverage this powerful tax deferral strategy to diversify your portfolio and preserve your head-earned wealth.
