Many small business owners and real estate investors join forces with other like-minded individuals to purchase real estate. However, over time the goals of each individual may diverge from the group, especially when it comes time to sell the property. One person may want to cash out, while others want to continue with a property or invest in a new property.
One of the unfortunate consequences of grouping together is that it can sometimes be difficult to exit the group without generating a taxable event. This article focuses specifically on a group of owners who have determined that they wish to sell a property but disagree on what to do with the money. In these cases, a legal/tax technique called the Drop and Swap can be extremely beneficial. In brief, the Drop and Swap technique provides flexibility to real estate investors who wish to part ways upon the sale of mutually owned property.
Typical Fact Pattern
Let’s start by looking at a simple, yet common set of circumstances:
- Two or more individuals are partners in a partnership entity, which we will call Entity. We will call the partners Individual A and Individual B.
- The partnership owns real estate. Whether it is residential, commercial, or undeveloped land does not matter.
- A and B agree that they want to sell the real estate.
- A and B disagree on what to do with the proceeds.
- For example, A may want to take the cash generated from the sale, while B wants to roll the proceeds into a new property through a 1031 exchange (a tax-free exchange of one property for another).
Why is that a problem?
Let’s consider two scenarios in which Entity, owned by A and B, sells the real estate:
- The real estate is sold by Entity.
- Cash will be received by Entity, which is then distributed to A and B.
- Tax will be assessed from the sale. The tax will ultimately be paid by A and B.
Individual A is satisfied because A received the cash from the sale. A will pay taxes out of that cash, but A is okay with that.
Individual B is not satisfied because B received cash from the sale and will have to pay taxes from that cash. Now B will be left with less money to invest in a new property.
- The real estate is exchanged by Entity.
- That means that old property is now gone, and Entity owns a new property.
- No cash was received. All the equity went into the new property.
- No taxes will be assessed.
Individual A is not satisfied because A wanted cash.
Individual B is satisfied because taxes were not paid, and therefore all the proceeds from the sale of the old property were used to acquire a new property.
Solution – Drop and Swap
The underlying problem is that Entity owns the real estate, not Individuals A and B. This means that when Entity takes an action that results in an outcome, A and B will experience the same outcome.
The Drop and Swap resolves this by “dropping” the ownership of the real estate out of the entity and to Individuals A and B. At that point, Individuals A and B are “tenants in common,” or co-owners, of the property. When the property is sold, Individual A and B are allocated the proceeds pro rata. Individual A can then receive cash from the title company. Individual B can “swap” into a new property by directing the title company to give the proceeds to a 1031 broker in a special escrow account. Individual B can then use those funds to invest in a new property. Individual A will pay taxes. Individual B will not.
To recap, here are the conceptual steps in order.
- Entity owns real estate. Individual A and Individual B are co-owners of Entity.
- Entity distributes the real estate to Individual A and Individual B.
a. This would be done either through a regular distribution, liquidating distribution, or Section 761(a) election (not common in my experience)
b. It would not be done through a sale or redemption, as that would generate tax by itself.
- Individual A and Individual B are now “tenants in common,” or direct co-owners, of the real estate.
- The real estate changes title from Entity to Individual A and Individual B as new co-owners.
- The real estate is sold.
- At closing, the following occurs:
a. The title company receives funds from the buyer or buyer’s lender.
b. Mortgage is paid off.
c. Sale expenses are paid.
d. Remaining cash is allocated between Individual A and Individual B.
e. Individual A receives cash.
f. Individual B directs the title company to send cash to a 1031 escrow account held by a 1031 broker.
- Entity is terminated as it is no longer needed.
- Individual A has received cash and will pay tax on their portion of the sale. The remaining cash can be used in whatever manner they wish.
- Individual B has put cash into 1031 escrow account.
- Individual B identifies new property to invest in.
- Individual B closes on new property
a. The 1031 broker gives cash held in escrow to new title company
b. Funding is received from new mortgage
c. Individual B contributes any additional cash needed to close
- Individual B now owns new property. No tax was paid (see note below)
This sounds great! What are the potential problems?
- Additional transaction costs will be incurred to pay the lawyer, accountant, 1031 broker, title company.
- Individual B will need to meet certain criteria to complete the 1031 without paying tax.
a. In simple terms, B will need to purchase a replacement property that is more expensive and has a larger mortgage than the property that was sold.
b. The replacement property must be identified within 45 days (about 1 and half months) of the sale. The purchase must then by closed on within 180 days (about 6 months) of the sale.
- Both individuals will take on some tax risk.
a. The IRS may decide that the holding period possessed by the entity does not transfer to the individuals.
b. Individual A would be at risk of the IRS determining that all gain was short-term and therefore the tax should be higher.
c. Individual B would be at risk of having the 1031 disqualified and treated as a sale. B would be taxed on cash he did not receive at the same rate as A.
d. This is unlikely to occur but is theoretically possible.
e. Protection would be gained by “dropping” the property well in advance of the sale. Either one calendar year before, or at least in the calendar year prior to the year the sale will occur.
- Reverse “Swap and Drop.” Typically, only used when both A and B want to roll cash into new properties, but they don’t want to roll into the same property. This is a complicated option, usually only used to make a particular deal work out.
- Straight 1031 with subsequent cash-out refi and redemption. This is also a more complicated transaction. The Entity would proceed with the 1031. After the 1031 is completed, cash would be obtained by refinancing the replacement property to obtain cash. The cash would then be used to redeem A’s ownership in the entity. I.E, A would be bought out by the Entity.
a. Both parties would get what they wanted, but A would have to wait awhile for the cash.
b. The replacement property would have to a much higher value and mortgage balance than would otherwise be required to make it work out for B.
c. Again, you would only see someone do this to make a particular deal work out.
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