Navigating Drop and Swap vs. Swap and Drop Strategies in 1031 Exchanges for LLC-Held Properties

When investment property is held in a limited liability company or partnership, executing a successful 1031 exchange requires careful planning and consideration of entity structures. Two related but distinct strategies have emerged to address the unique challenges presented by multi-member LLCs and partnerships: the "drop and swap" and the "swap and drop" approaches. Understanding the nuances, timing requirements, and potential pitfalls of each strategy is essential for real estate investors seeking to maximize tax deferral opportunities.

The Challenge of Entity-Held Property

Section 1031 of the Internal Revenue Code permits taxpayers to defer capital gains taxes when exchanging investment or business property for like-kind property. However, the exchange must be executed by the same taxpayer who held the relinquished property and will hold the replacement property. This creates a significant obstacle when property is owned by a multi-member LLC or partnership, as the entity itself is the taxpayer, not the individual members.

When members of an LLC or partnership wish to go their separate ways or when individual investors want to exchange into properties with different investment objectives, the entity structure can prevent a straightforward 1031 exchange. An LLC interest or partnership interest is generally considered personal property rather than real property, and therefore cannot be exchanged for real estate in a tax-deferred transaction. This fundamental limitation has given rise to two strategic approaches: drop and swap, and swap and drop.

The Drop and Swap Strategy

The drop and swap strategy involves dissolving the LLC or partnership interest before initiating the 1031 exchange. In this approach, the entity distributes the real property to its members as tenants-in-common based on their respective ownership percentages. Once the individual members hold direct ownership of the real property, each member can then independently execute a 1031 exchange into replacement property of their choosing.

For example, if three partners each own one-third of an LLC that holds an apartment building, the LLC would be dissolved and the property would be distributed to the three individuals as tenants-in-common, each owning an undivided one-third interest. Subsequently, each individual could exchange their one-third interest into a replacement property, whether that be another tenant-in-common interest, a wholly-owned property, or a Delaware Statutory Trust interest.

Timing and the Step Transaction Doctrine

The critical consideration in a drop and swap transaction is timing. The IRS has historically scrutinized these transactions under the step transaction doctrine, which can collapse separate steps into a single taxable transaction if they are part of an integrated plan. Revenue Ruling 2019-04 provided welcome clarity on this issue, explicitly approving drop and swap transactions when the distribution of property to members occurs at least twelve months before the exchange. This twelve-month holding period has become the industry standard for establishing that the distribution and the exchange are separate transactions with independent economic significance.

Beyond the twelve-month minimum, taxpayers must demonstrate legitimate business purposes for the distribution and treat the property as directly owned during the interim period. This means the individual members should report rental income on their personal tax returns, handle management decisions as tenants-in-common, and otherwise demonstrate that they are not merely holding the property in anticipation of an immediate exchange.

The Swap and Drop Strategy

The swap and drop strategy reverses the sequence: the LLC or partnership first executes a 1031 exchange into replacement property, and then subsequently distributes that replacement property to the members. This approach allows the entity to complete the exchange while preserving flexibility for the members to eventually take individual ownership.

Using the same example, the three-member LLC would sell the apartment building and exchange into replacement property as an LLC. After the exchange is completed and the replacement property is acquired in the LLC's name, the LLC could later distribute the replacement property to the three members as tenants-in-common based on their ownership interests.

Revenue Ruling 2019-04 also addressed swap and drop transactions, requiring a twelve-month holding period after the exchange is completed before the replacement property is distributed to members. The ruling established that if the LLC holds the replacement property for at least twelve months and conducts legitimate business activities during that period, the subsequent distribution will not retroactively invalidate the 1031 exchange.

Similar to drop and swap requirements, the LLC must treat the replacement property as an ongoing investment during the twelve-month period. The entity should collect rents, pay expenses, make management decisions, and otherwise demonstrate that it acquired the replacement property with the intent to hold it for investment rather than as a temporary holding mechanism before distribution.

Comparing the Two Strategies

The choice between drop and swap and swap and drop depends on the specific circumstances and objectives of the investors involved. Drop and swap offers greater flexibility for members who have different investment goals, as each individual can independently select their replacement property immediately after the distribution. This approach works well when members want to pursue divergent investment strategies or when some members want to exchange while others prefer to cash out and pay taxes on their gains.

Swap and drop provides advantages when members want to maintain unified ownership through the exchange process but anticipate separating in the future. This strategy can be beneficial when the property being sold requires coordinated marketing and negotiation as a single asset, or when the replacement property is best acquired as a unified entity before eventual distribution. Additionally, swap and drop can offer more certainty during the exchange process, as the entity structure remains intact through the critical 45-day identification period and 180-day exchange period.

Partnership Agreements and Operating Agreements

Regardless of which strategy is employed, the existing partnership agreement or LLC operating agreement must permit the contemplated transactions. Many operating agreements contain restrictions on distributions, requirements for member approval, or limitations on dissolving the entity. Investors should carefully review these governing documents well in advance and amend them if necessary to facilitate the desired strategy.

Some agreements may require unanimous consent for dissolution or distribution of property, while others may permit such actions with a simple majority vote. The agreement may also contain provisions addressing how property should be valued for distribution purposes or how debts and liabilities should be allocated among members. These contractual obligations must be satisfied in addition to the tax law requirements for a successful transaction.

Debt Considerations

When property held by an LLC or partnership is encumbered by debt, both drop and swap and swap and drop transactions require careful attention to debt allocation and assumption. In a drop and swap scenario, the debt must be appropriately allocated among the members receiving the distributed property, which may require refinancing or obtaining lender consent for the distribution.

Each member receiving distributed property must take on their proportionate share of debt, or some members must pay off others' debt obligations to achieve the desired allocation. This can create complications if lenders are unwilling to release some members from liability or if individual members cannot qualify for financing on their proportionate share.

State Law Considerations

State law governing LLCs and partnerships varies significantly and can impact the feasibility and mechanics of both strategies. Some states impose transfer taxes on distributions of real property from entities to members, which could create unexpected costs. Others have specific statutory requirements for dissolving entities or distributing property that must be satisfied.

Additionally, the characterization of property ownership after a distribution can vary by state. While members generally receive the property as tenants-in-common in a drop transaction, some state laws may impose different default ownership structures. Investors should work with qualified legal counsel familiar with the relevant state's laws to ensure compliance and optimal structuring.

Revenue Ruling 2019-04 and Current IRS Position

Revenue Ruling 2019-04 marked a significant development in the IRS's approach to these transactions, replacing earlier, more restrictive guidance from Revenue Ruling 77-337. The 2019 ruling explicitly approved both drop and swap and swap and drop transactions when the twelve-month holding period is satisfied and other requirements are met.

The ruling analyzed two scenarios: in Situation 1, a partnership distributed property to partners who subsequently exchanged their interests, and in Situation 2, a partnership completed an exchange and then distributed the replacement property to partners. The IRS concluded that in both situations, the exchange qualified for non-recognition treatment under Section 1031 when the twelve-month holding period and other requirements were satisfied.

Working with Qualified Professionals

Given the complexity and high stakes involved in drop and swap or swap and drop transactions, investors should engage experienced professionals throughout the process. A qualified intermediary is required to facilitate the 1031 exchange component of either strategy, and their expertise in structuring the exchange timeline and documentation is invaluable.

Tax advisors familiar with partnership taxation and Section 1031 can help navigate the intricate rules surrounding basis allocation, debt allocation, and holding period requirements. Real estate attorneys can address entity governance issues, draft necessary amendments to operating agreements, and ensure compliance with state law requirements for distributions and dissolutions.

Additionally, investors should consult with their lenders early in the planning process, as debt restructuring or refinancing may be necessary to accommodate the distribution of property from the entity. Coordination among all these professionals is essential to execute a successful transaction that achieves both the operational and tax objectives of the investors.

Conclusion

Drop and swap and swap and drop strategies offer powerful tools for real estate investors seeking to navigate 1031 exchanges when property is held in multi-member LLCs or partnerships. Revenue Ruling 2019-04 has provided much-needed clarity on the requirements for these transactions, establishing the twelve-month holding period as a key benchmark for success. However, these strategies require meticulous planning, careful attention to timing, and coordination among legal, tax, and exchange professionals. When properly executed, they enable investors to achieve tax deferral while obtaining the flexibility to pursue their individual investment objectives. Understanding the distinctions between these approaches and their respective advantages allows investors to select the strategy best suited to their specific circumstances and goals.