What Is a Drop and Swap?

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September 1, 2022

Illustration of a house and arrow pointing to a dollar sign

Typically, many investors purchase commercial real estate assets through limited liability companies (LLCs) or partnerships because they are expensive. When these partnerships are no longer needed due to conflicting interests, a drop and swap is done so that all members can benefit. So, what is a drop and swap?

What Is a Drop and Swap?

A drop and swap is a type of 1031 exchange. It refers to the process through which real estate investors drop out of a partnership interest or a limited liability company (LLC) into an ownership interest and then swap or exchange their current investments for a similar real estate investment.

Commercial real estate buildings

While you can employ this process in different transaction scenarios, it is most suitable to use when you sell a property that you bought through a partnership and some of the partners are unwilling to reinvest as partners.

How Does a Drop and Swap Work?

A drop and swap is a remedy for partners who don’t want to pay tax on their sales earnings. It involves legal procedures that authorize the dissolution of the partnership that owns the property and the reinvestment of sales earnings for partners who decide to take part in the exchange.

This transaction works the same way as a 1031 exchange; it allows taxpayers to hold off on paying capital gain taxes on the profitable sale of real property, provided you reinvest these earnings in real property of the same kind. As the name suggests, this transaction follows two stages:

  • The drop
  • The swap

The Drop

Before you sell the property, you have to first dissolve the partnership or Limited Liability Company, and the Tenancy In Common interests are distributed among the partners. These investors, who are now individual owners, can then sell the relinquished property to any individual or entity who wishes to buy it. 

The Swap

After the dissolution of the partnership and selling of the relinquished property, the partners who wish to reinvest then “swap” their share of the earnings for a stake in the replacement property, however, partners who do not want to reinvest their share of the earnings will have to pay taxes on the profits.

What Are the Requirements for a Drop and Swap?

To carry out this transaction in the Cincinnati/ Northern Kentucky areas successfully, the investors must meet a few requirements. These requirements include:

Holding Time

For the strategy to be completed and implemented, the properties involved must be held for business, trade, or investment purposes. Although the IRS doesn’t say how long you must hold a property, there is a risk that they may deny the “swap” into the replacement property if the dissolution of the partnership occurs too close to the property sale.

Illustration of a house and arrow pointing to a dollar sign

It would be wise for investors to work with qualified 1031 tax experts and real estate advisors like Si Vales Valeo Real Estate, who have ample experience with 1031 exchanges and the strategy involved here.

Filing an Election

After you have dissolved the partnership and distributed the Tenancy In Common (TIC) interests among the partners, you have to file a section 761(a) election while waiting to get a sale on the property. This is to notify the IRS that the ownership entity should no longer be taxed as a partnership.

Periodic Operating Expenses

Proving to the IRS that all individuals involved in the property investment are no longer partners and are instead Tenants In Common is necessary. To do this, periodic proportional payments of the property’s operating expenses should be made individually for a reasonable amount of time.

Negotiating as Individual

When it is time to sell the property investment, negotiations and meetings on the sales agreements should be done as individuals, not partners. This will allow everyone involved in the transaction to include their percentage interest in the sale.

Advantages of a Drop and Swap

This strategy provides two significant advantages for investors in the Cincinnati area, mainly in the areas of:

  • Tax deferral
  • Flexibility 

Tax Deferral

If the transaction is completed successfully, it permits investors to defer capital gain taxes on the profitable sale of the relinquished property as long as they reinvest in the replacement property. This transaction can be done an indefinite number of times until the investors involved decide they want to pay taxes.

Flexibility

With this strategy, investors have extra flexibility to work around the competing investment priorities of other partners. Every investor gets a chance to drop out of a partnership and walk away or reinvest in the replacement property.

Alarm clock beside coins lined up together with a miniature wooden house

Problems With a Drop and Swap

Like any other investment strategy, this one comes with problems that can cause complications in the transaction. Here are some issues to watch out for:

Execution Risk

There are a lot of intricacies involved in using this strategy, and getting any of them wrong could result in the disqualification of the transaction by the IRS, causing it to become taxable.

Time Constraints 

In this transaction, the reinvesting partner must identify the replacement property within 45 days of the relinquished property’s sale and close on the purchase within 180 days of the sale date. These time constraints can put investors under pressure and cause them to make wrong decisions in a haste.

However, these problems are nothing that cannot be solved with the help of the right professionals. Hiring a real estate agency to handle your transaction will significantly increase the chances of the exchange going smoothly. 

Related Questions

Can I Buy a Business With a 1031 Exchange?

Yes, you can buy a business with a 1031 exchange. Investing in a business can be costly when considering taxes. A 1031 exchange is an excellent choice because it allows you to buy a business with the earnings from selling an investment property.

Can You 1031 as a Limited Partner?

No, you cannot 1031 as a limited partner. The IRS strictly bans partnership interest exchanges in a 1031 exchange transaction. These exchanges are not permitted irrespective of whether the interests are limited partnership or general interests.

Conclusion

The possibility of deferring taxes indefinitely would explain why many investors practice this strategy.  However, this investment strategy is as risky as it is beneficial. Hiring Si Vales Valeo Real Estate to handle your investments will ensure that your interests are duly protected and your investment goals are achieved. 

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