A “drop and swap” 1031 exchange is a strategy used by real estate investors to facilitate a tax-deferred exchange under Section 1031 of the Internal Revenue Code, particularly when dealing with properties held in a partnership or LLC. This approach is often employed when some partners want to cash out of the investment while others wish to continue deferring taxes by reinvesting in like-kind property.

Here’s how a drop and swap typically works:

1. Drop: Before the exchange, the partnership or LLC “drops” the ownership of the property to the individual partners or members. This is done by distributing the property to the partners as tenants-in-common (TIC) interests. By doing so, each partner holds a direct interest in the property, rather than an interest in the partnership or LLC.
2. Swap: Once the property is held as TIC interests, the individual partners can proceed with a 1031 exchange. Those who wish to defer taxes can exchange their TIC interest for a like-kind property, while those who want to cash out can sell their interest and recognize the gain.

To illustrate this with an example, let’s say you and your partners own a commercial property through an LLC. The property is valued at $1,000,000, and there are four partners, each with a 25% interest. Two partners want to cash out, while the other two want to reinvest in a new property.

Step 1: Drop

The LLC distributes the property to the partners as TIC interests. Now, each partner directly owns a 25% interest in the property.

Step 2: Swap

• The two partners who want to cash out sell their TIC interests and recognize their share of the gain.
• The other two partners, who want to defer taxes, engage in a 1031 exchange. They use Deferred.com as their qualified intermediary to facilitate the exchange. We handle the sale of their TIC interests and hold the proceeds.

Example Exchange

Let’s say the two partners who want to defer taxes have a combined TIC interest valued at $500,000. They identify a replacement property worth $500,000 within the 45-day identification period and complete the purchase within the 180-day exchange period. By using Deferred.com as their qualified intermediary, they ensure that they do not have constructive receipt of the funds, which is crucial for maintaining the tax-deferred status of the exchange.

In this scenario, the two partners who reinvested in the new property have successfully deferred their capital gains taxes, while the other two partners have cashed out and recognized their gains. The drop and swap strategy allows for flexibility among partners with different investment goals, while still taking advantage of the tax deferral benefits of a 1031 exchange.

It’s important to note that the drop and swap strategy can be complex and may attract scrutiny from the IRS. Therefore, it’s advisable to work closely with tax professionals and legal advisors to ensure compliance with all applicable regulations. At Deferred.com, we are here to assist you with our qualified intermediary services, ensuring a smooth and compliant 1031 exchange process.