Timing is everything: Drop and swap transactions need extra attention
A recent ruling by the California Board of Equalization serves as a good reminder that proper planning is of utmost importance when considering a drop and swap transaction.
In late 2016, the board found that a 1031 exchange transaction involving an LLC that distributed its interests down to the members prior to a sale should have been attributed to the LLC, not the individual members. As a result, the exchange was disallowed and penalties were assessed.
What is a drop and swap?
A drop and swap is a term used for a real estate transaction where an entity with multiple members or partners changes the property title to reflect the individual names, and is followed by a 1031 exchange. It’s often used as a tax strategy when some members of the partnership want to defer capital gains taxes while others would rather cash out and pay taxes.
However, a poorly executed attempt at employing this strategy can have consequences. While it is a common practice, be aware you may bring higher risk of exposure for an IRS audit, and if it’s found that you were intentionally trying to evade taxes, you could face penalties.
The case facts reviewed
In this particular case, the board determined that the LLC held itself out as the seller to the buyer, broker, escrow company and the bank—and the individual members simply stepped in after the sale was already nearing completion.
In coming to their decision, the board considered and discussed numerous factors:
- Who negotiated the sale
- Who entered the purchase agreement
- Who signed the documents
- The amount of time that passed between the negotiation and the sale
- The motivation behind the distribution out to the members prior to the sale
As illustrated by this situation, a major factor for protecting yourself includes ensuring you have adequate hold time after the title change.
Could this have been avoided with proper planning? It certainly serves as a good reminder to devote thoughtful attention any time you are considering a drop and swap transaction. It’s not uncommon for exchanges to be disqualified due to transfers which occurred immediately before or after an exchange. Timing is everything.
There are other ways an exchange may be challenged, so obtaining professional advice before pursuing this complicated strategy may help you fully understand the related tax implications.
If you have any questions or would like assistance structuring such an exchange, contact Kenneth Zacharias at 920-455-4207, or ask for any member of the Schenck Real Estate & Construction team.
Kenneth Zacharias, CPA, has a broad background in income tax and general business consulting. He has extensive experience in taxation issues concerning real estate, including like-kind exchanges, use of partnerships and LLCs, construction and developer issues, and capital gains planning.