Drop and Swap - Dissolution of Partnerships Prior to Exchanging

What is a Drop & Swap?

When a partnership is selling real property and some of its partners want to cash out, while others want to reinvest their proceeds in new property, complications arise if the reinvesting partners wish to utilize a 1031 exchange. First, for 1031 purposes, a sale of a property interest owned through an interest in a partnership is considered a sale of the partnership interest. Under IRC § 1031(a)(2)(D), partnership interests are not exchangeable. Second, the taxpayer that sold the relinquished property must acquire the replacement property. For example, if a partnership sells the relinquished property to a buyer, that same partnership must buy any replacement property acquired through an exchange. Individual partners may not exchange into replacement property with proceeds from the partnership’s sale.

A common solution to the above dilemma is for the partners to dissolve their partnership prior to the sale and distribute proportionate tenant in common (“TIC”) interests in the property to each of the individual partners (the “drop”). The individual owners then deed the property to the buyer. Some of the former partners exchange their interests into replacement property (the “swap”), and the others take their cash proceeds and pay tax on their gain.

Risks of a Drop & Swap

While a drop and swap is a common structure, it is not without tax risk. In order to qualify for 1031 treatment, the property sold and the property purchased must be “held for investment” to meet the “qualified use” test that determines 1031 eligibility. Although the code does not include a specific minimum timeframe for which property must be held, if the relinquished property is transferred to the individual partners from the partnership immediately prior to its sale, the IRS may take the position that the individual partners acquired the property not for investment purposes, but for the sole purpose of selling it. Even if the original owner, the partnership, had owned the property for many years prior to the drop and swap, the individual partners may not be able to benefit from the partnership’s prior holding period. The IRS or applicable taxing authority may also take the position, using the “substance over form” doctrine, that the property interests distributed to each partner and then exchanged were in essence partnership interests, which are excluded from nonrecognition treatment as mentioned above.

It is important to note that partnership federal income tax returns include two questions in the Schedule B portion of form 1065 that draw attention to any drop and swap transactions and heighten a taxpayer’s risk of audit. Therefore, a taxpayer should be fully prepared to defend the transaction should they decide to move forward with a drop and swap exchange.

Question 11 on Schedule B of form 1065 is to be checked yes if:

“…during the current or prior tax year, the partnership distributed any property received in a like-kind exchange or contributed such property to another entity (other than disregarded entities wholly-owned by the partnership throughout the tax year)”

Question 12 asks:

“At any time during the tax year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property?”

Precedent for and Against the Drop & Swap

There have been several IRS rulings that have disqualified exchanges, reasoning that there was a qualified use issue (as referenced above), because the taxpayers dropped out of a partnership immediately before or immediately after an exchange.[1] Courts, however, have often interpreted the holding period requirement more liberally and have permitted non-recognition of gain in 1031 transactions, even when there was a transfer immediately before or after the exchange from or to an entity controlled by the taxpayer.[2]

In addition to some favorable case law, the IRS decided in favor of the taxpayer in Private Letter Rulings 200521002 and 200651030.[3] Both Private Letter Rulings addressed a testamentary trust that owned real estate and regularly did 1031 exchanges. The trust was due to terminate at a certain time and, per the trust’s termination plan, the assets of the trust would eventually be held in an LLC. The trust was expected to terminate during the exchange period in two of its transactions and immediately after the completion of a 1031 exchange in a third transaction. In each ruling, the IRS held that the termination of the trust and subsequent transfer of the properties to the LLC would not ruin the 1031 exchange transactions.

Despite these positive decisions, the IRS has not published any rulings that give investors certainty regarding the ability to defer tax in an exchange if the taxpayer uses a drop and swap structure.

Moreover, there are other methods by which the IRS may challenge a drop and swap transaction. For example, partners who drop down to tenancy in common ownership but continue to operate as a partnership for their profit and loss allocations or for their sale agreement negotiations may have a hard time arguing that they are not still operating as a partnership. In this situation, the IRS would likely find that the substance of the transaction occurred at the partnership level, rather than the individual level.[iv]

Drop & Swap Treatment in California

Within the last few years, California taxing authorities have paid increasing attention to drop and swap transactions. In late 2007, the California Franchise Tax Board (“FTB”) issued a notice with regard to its examination of like kind exchanges involving TIC interests.[v] The notice indicated that the FTB would be examining whether TIC interests were actually disguised partnership interests. Although taxpayers have relied on Revenue Procedure 2002-22 to structure their TIC transactions, the FTB stated that the conditions set forth in the Revenue Procedure would be considered minimum requirements for determining the existence of a TIC interest in rental real estate. This notice serves to remind investors that a TIC interest may be characterized as a partnership interest if the transaction is not structured properly, potentially ruining an exchange.

Also in California, the Board of Equalization (BOE) issued a 2016 ruling where it agreed with the FTB in challenging an exchange using the substance over form doctrine, deciding that the sale by individual members of an LLC that had dropped out its interests should actually be seen as a sale by the LLC, disallowing the exchange.[vi] There is one 2018 case from California where the Office of Tax Appeals in California (OTA, successor in interest to the BOE) reversed the FTB’s determination that a drop and swap exchange was invalid.[vii] In that case, they reasoned that because there was a valid business purpose of the redemption of two partners’ general partnership interests in a partnership that owned real property being sold, their dropping their interests out of the partnership simultaneously with the sale to a buyer was valid. However, later OTA decisions seem to contradict this reasoning, and the opinion is non-precedential – taxpayers in California should therefore be diligent when documenting any transactions surrounding their drop and swap and exchange transaction.

As recently as 2022, the OTA upheld the FTB’s decision to deny 1031 treatment to an exchange where after a partnership dropped its interests down to the individual taxpayers, the former partners failed to individually exercise incidents of ownership over the property prior to exchanging.[viii] Factors that the decision highlighted as important to consider in determining whether individual former partners can show they are the true sellers of a property after a partnership is dissolved and the interests distributed included: (1) Did the partnership, or the individual owners, take an active role in the sale and negotiations for sale of the property? (2) Did the former partners conduct negotiations on their own behalf with the buyer? (3) How much time elapsed between partnership negotiations and the exchange? (4) Was the sale conducted under substantially the same terms as negotiated by the partnership? (5) Did the partners receive the benefits and burdens of ownership of the property, prior to its sale?

CONCLUSION

A drop and swap is a complicated transaction with a variety of tax implications. Below are some practical tips; however, investors should work closely with their CPA or attorney and analyze all of the tax issues involved with their specific transaction:

Drop out of the entity as early as possible before the closing of the relinquished property;
Hold the replacement property for a sufficient amount of time prior to transferring to any entity;
Maintain adequate records in order to establish evidence of intent to hold the relinquished or replacement property for business or investment purposes;
When dropping into TIC interests, follow as many of the criteria set forth in Rev. Proc. 2002-22 as possible, i.e., share in the profits and expenses on a pro rata basis;
Examine the relevant case law in addition to Revenue Procedure 2002-22; and
When selling the relinquished property, negotiate and enter into the sale agreement as individuals.

[1] See Revenue Ruling 77-337, 1977 WL 43782 (1977); Revenue Ruling 75-292, 1975 WL 35378 (1975)

[2] See Magneson v. Commissioner of Internal Revenue, 753 F.2d 1490 (US TC 1985); Bolker v. Commissioner of Internal Revenue, 760 F.2d 1039 (1985); Maloney v. C.I.R., 93. T.C. 89, Tax Ct. Rep. (CCH) 45863 (1989)

[3] PLR 2005-21002 (February 24, 2005); PLR 2006-51030 (September 19, 2006)

[iv] See Chase v. Commissioner of Internal Revenue, 92 T.C. 874 (1989)

[v] California Franchise Tax Board Notice 2000 1107 02

[vi] See In re Matter of the Appeal of Giurbino, Taxpayer, 2016 WL 10005734 (Cal. St. Bd. Eq.)

[vii] See In the Matter of the Appeal of Sharon Mitchell, 2018 WL 10560573 (Ca. Off Tax App. 8/2/18)

[viii] See F.A.R. Investments, Inc. (OTA Case Nos. 19125618 and 19125619)

First American Exchange Company, LLC a Qualified Intermediary, is not a financial or real estate broker, agent or salesperson, and is precluded from giving financial, real estate, tax or legal advice. Consult with your financial, real estate, tax or legal advisor about your specific circumstances. First American Exchange Company, LLC makes no express or implied warranty respecting the information presented and assumes no responsibility for errors or omissions.

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