Believe it or not, there are investors out there with gain on properties that they have held for business use or investment. When they reach a time that they feel is the perfect time to sell, they must come to terms with the fact that this gain will carry with it some hefty tax liability. A 1031 Exchange is an ideal solution to this predicament. What happens when the taxpayer is a partnership comprised of several partners who are not all on board with doing an exchange? Let’s take a look at this example:
Real Estate Pros is a partnership that owns a rental unit on Fort Myers Beach. The partnership is comprised of 3 individuals. They got a great offer to sell their unit on the beach, and they have decided to accept. When all is said and done, they are looking at over $75,000.00 in taxable gain. Two of the partners determine that a 1031 exchange is the best option to defer the capital gains and depreciation recapture taxes. The third partner does not want to invest in any other properties. He would like to just cash out. So what do you do? How do you work it so that all parties are happy? A popular question that comes up is, “What if we take the property out of the partnership and deed it into each of the partners’ names prior to closing on the sale?” This is referred to as a drop and swap, where you are dropping title from the partnership entity into the individual names, and then doing the swap. In theory, this sounds like the perfect solution. Those that want to exchange can, and those that do not simply take their cash at closing and move on. Unfortunately, because the property is owned by the partnership, there is no way to have some of the partners do a 1031 and others simply cash out. It’s an all or nothing deal. Either all of the partners agree to 1031, or none of them get to. The drop and swap is a controversial topic. Depending on who you talk to, some say that this is ok, and others will tell you that this will not work.
Let’s take a step back and look at the transaction from a distance. The property in question has been owned by the partnership (and under the partnership’s tax id number) up until the time of the
“drop”. Once title is dropped into the names of the individual’s, it is now under their personal tax id numbers. When they go to sell the property, they are now selling under their own tax id numbers. The issue is that they have not satisfied the “held for investment” requirement prior to the exchange, at least not under their tax id numbers. One would think that since the partnership did satisfy the holding requirement, the individuals are covered. This is not the case. We are dealing with two different tax id numbers. Once the individuals took title to the property, a new clock started.
These types of transactions of have come under a great deal of scrutiny by the IRS. If you have no choice by to do a drop and swap, your first call needs to be to your tax and legal counsel so that you can be sure to implement several strategies that will hopefully help to lessen the odds of your exchange being disqualified. For more information on 1031 Exchanges, call us at 239-333-1031 or visit www.1031company.com.
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