Coordinating a 1031 exchange for limited liability companies or partnerships can present a unique set of challenges.  If the entity itself will remain intact, the partnership or the LLC can sell its property and purchase replacement property through the 1031 exchange process.  However, a common issue that arises is that not all of the members or partners can agree on a property to purchase, or even if they want to do an exchange at all. 

Investors in this situation often use a “Drop and Swap” structure to complete their transaction.  This term applies to dropping the property out of the LLC or partnership to the individual members, and then each member could do a 1031 exchange or “swap” into their own replacement property.  Although this method has been applied for years, there are some risks.

The biggest risk with this type of transaction is that, if audited, the individual members may not be able to show that the property was held for productive use in a trade or business or for investment as Section 1031 requires.   In other words, the individual members only held title for a short time and only with the intent to sell the property.  Therefore, the “held for” requirement of Section 1031 has not been met.

Click here to learn more about risks involved with drop and swaps, recent developments, and tips for structuring your exchange.

As with any transaction, taxpayers should consult with their tax professional about their specific circumstances.