Drop and Swap Fundamentals for Partnerships and LLC’s
By Cliff Hockley, President of Bluestone and Hockley Real Estate Services
Executive Director, SVN | Bluestone and Hockley
Net operating income (NOI) is the driver of value in real estate investing. Unfortunately for many properties during COVID, the NOI has been capitated due to the mandated residential eviction moratoria (City, State, Federal), that run through the end of 2020. In 2021, as tenants find their footing and figure out how to pay rent, owners of investment properties will be able to re-establish the values of their current investments. This makes it a good time to build the TIC structure needed for a “drop and swap”, to trade up and out of your current investment.
The “drop and swap” strategy is commonly used when real estate partners decide to go their separate ways in individual 1031 tax-deferred exchanges when an investment property is sold.
There are a couple of reasons for this, under IRC § 1031(a)(2)(D), partnership (read as LLC) interests are not exchangeable, additionally, the taxpayer that sells the relinquished property must acquire the replacement property. For example, if the four partners of an office park sell a property, that same partnership must buy the replacement property. If one of the partners wants to leave the partnership and buy a replacement property for themselves, say an industrial building, with their share of the exchange, it will disqualify their exchange unless they (all of the members of the existing LLC) do a drop and swap first.
Drop and Swap
In this investment structure, the partnership (LLC) is dissolved prior to the sale and reformulated into a Tenant in Common (TIC) entity. LLC members (partners) distribute their common interests in the property to the individual partners in the form of a TIC (this is the “drop”). They can then use the cash they earned in the sale to independently purchase their new real estate investments (the swap), or they can take the cash and pay tax on the gain rather than continuing to invest with their LLC group.
Holding period
A taxpayer doing an exchange must show that they have had the intent to hold the property as an investment. To ensure that the IRS does not disqualify a future 1031 exchange, investors should wait at least one filing period, preferably two,( i.e. two tax return periods) to age the transaction, to meet the “held for the requirement.” Length of time in ownership is one of many ways to prove investment intent.
If you wait to make plans for a drop and swap after you have accepted an offer to sell a property, you will have demonstrated intent to sell and the IRS may disallow the 1031 exchange you were planning on taking. Do not mix the two business decisions, dropping into individual ownership, and selling together. If you mix the two decisions together, the IRS could easily argue your intent was to take a series of steps to avoid taxes.
Lenders
When you change the structure of your relationship from a partnership (LLC) to a TIC you need to get approval from your lender. Lenders may charge you for a review of the players and may refuse to allow the transfer. They will put all the investors through a financial review and may want a current appraisal of the property to confirm its value as well. This is not a rubber stamp process. Getting approval from a lender might take up to six months or longer and occasionally a lender may ask for additional accommodations to rewrite the ownership of the deal. Leave yourself lots of time to get this done, especially with national banking entities that have many layers of bureaucracy. Do not forget to plan on spending time with the lender, your 1031 accommodator, your real estate broker, CPA, and an experienced real estate attorney to draft up TIC documents. (Of course, there is an additional time and cost involved with a drop and swap, so plan accordingly).
Summary
The light is on the horizon as we find a way to combat and win our worldwide battle against COVID -19. Real estate transactions will shortly resume their proper place in the investment landscape, and we will restart to buy, sell trade our investments. As the world right’s itself, and you are considering exiting from a partnership, this is a good time to contemplate and invest in your transition from an LLC ownership structure to a TIC structure. It takes a significant amount of time and money to get this done properly, now is the time to get started with planning your exit strategy if you plan on closing deals in the spring of 2021.
Referral Sources:
https://www.firstexchange.com/pages/drop-and-swap
https://www.accruit.com/blog/drop-and-swap-or-swap-and-drop
http://www.1031.us/PDF/Planning%20for%20a%20Drop%20and%20Swap%20Article.pdf
https://www.investopedia.com/terms/t/tenancy_in_common.asp