Realty Exchange News
By Bill Horan –
The “Drop and Swap” is a term used to describe the process of dropping out of a partnership or membership interest of a limited liability company (LLC) into an ownership interest in investment real estate and then exchange or swap for new investment real estate. The objective is to get into a position that allows you to exchange your real estate into new real estate and defer the taxes due on your gains.
There are pros and cons of a drop and swap and several variations all of which can be complicated, but a drop and swap is a valuable planning strategy to hang onto your hard earned gains.
Partnership or LLC is the owner
When multiple people come together to buy real estate, it is very common for them to form a partnership or a limited liability company (LLC) to hold the title to the property. This form of ownership typically has its own tax identification number and files its own tax return. In most cases the income and expenses are distributed to the owners of the partnership on an IRS form K-1. Many people have the mistaken understanding that they own real estate when, in fact, they own an interest in an entity which owns the real estate.
When it is time to sell the real estate and the real estate has gain, Uncle Sam and Aunt NC want a percentage of the gain. Section 1031 of the tax code allows the owner of property to exchange/swap for new replacement property and defer paying the taxes.
The process defined in Treasury Regulation 1.1031, has very specific steps and timing parameters to accomplish an exchange properly. If a partnership or LLC owns the real estate, the partnership or LLC can do an exchange, as it is a tax entity, filing a tax return under its own tax ID number. The individual partners or members cannot exchange their interests; the code is very clear on this issue (IRC §1031(a)(2)(D)).
It is very common that not everyone in the partnership wants to remain in the partnership and buy new replacement property. Typically each member wants to go in their own direction. Some don’t want to pay taxes, and others are willing to do so.
Plan for the eventual sale and don’t wait to restructure
The language of the 1031 law says you can exchange property that was held for investment or business purpose for new investment or business replacement property to be held. The only way to defer taxes is to actually own the real estate and exchange for new real estate.
The “Drop and Swap” strategy is to drop out of the partnership into a percentage ownership interest in the real estate.
As an example, if three people are equal members of an LLC which owns a rental beach house, the drop and swap strategy would have them terminate the LLC, file a final tax return for the LLC, and distribute the ownership of the real estate to the members. This would be changing the title of the rental beach house to reflect three individual tenants-in-common owners. The tenant-in-common owners should then have a tenant-in-common agreement reflecting how the property should be managed—similar to a partnership agreement, but for tax purposes, not a partnership.
Bill Horan, CES® (a Certified Exchange Specialist®), is the President of Realty Exchange Corporation in Gainesville, VA. Call 800-795-0769 or e-mail firstname.lastname@example.org.
For more information about how an IRC 1031 can benefit real estate investors, please go to www.northbeachsun.com.