The “Drop and Swap” exchange is a useful tool for a partnership that desires to sell investment property and when some of the partners want to cash out, but others want to reinvest. The most common purpose for these transactions is to add or remove a co-owner of investment property. However, there are some obstacles that the taxpayer must overcome to successfully complete a Drop and Swap exchange.
Internal Revenue Code (“IRC”) 1031 requires that the same taxpayer who holds the relinquished property must acquire the replacement property. For example, if a partnership owns the investment property, a successful exchange requires the same partnership to purchase the replacement property. If the partnership sells the investment property, and only a few of the individual partners purchase the replacement property, there will not be a valid exchange.
The Drop and Swap exchange enables a valid exchange to occur by dissolving the partnership, filing a last tax return, and distributing the ownership interests in the investment property to the individual partners as Tenants in Common (“TIC”). This type of exchange does carry with it a certain amount of risk.
Specifically, the TIC must avoid classification as a de facto partnership in the eyes of the IRS. To do this, a Tenant in Common Agreement must be drafted, specifying all ownership and management rights of the TIC. Implementing a TIC Agreement is particularly important in light of Revenue Ruling 2002-22, as the IRS requires a genuine TIC arrangement, rather than a continuation of the partnership, in order for the taxpayer to effectuate a valid exchange.
Once the TIC arrangements are made, the taxpayer must meet the “holding” requirement under Section 1031. Under the code, the property must be “held for investment or business purposes.” The TIC must meet the holding requirement as individual TIC owners and will be unable to use the time the partnership held the investment property to meet the holding requirement.
The IRS and tax courts have not specified a length of time needed to satisfy the holding requirement. The IRS generally disfavors short periods of time (less than a year). However, Courts have upheld shorter holding periods (three months) if there was a genuine intent to hold the property for investment/business purposes. This becomes a question of fact for the tax court, which would examine all of the circumstances surrounding the exchange. The best practice is to err on the side of caution and attempt a longer holding period.
Drop and Swap exchanges are very complex transactions, but when used accurately, can enable a taxpayer to complete a valid exchange. A taxpayer should work closely with their CPA and attorney to ensure all requirements are met prior to effectuating an exchange of this type.
Feel free to reach out to a BrownWinick tax attorney.