Section 1031 of the U.S. Tax Code was put in place by Congress in 1921. This Code provision allows for tax deferral on real estate transactions assuming certain requirements are met. Some of the requirements appear directly in the Code section, but others appear in the detailed Treasury Regulations issued in 1991. Although the 1031 exchange rules are at the federal level, the individual states throughout the country have specific regulations that may allow for state tax deferral provided the federal based rules are followed.
Review of 1031 Exchange Basics
The basic requirements of a valid exchange are straightforward: sell a qualified property and treat it as the first leg of the exchange through the use of a Qualified Intermediary; have the net cash held outside the Exchanger’s control; identify potential qualifying Replacement Property within 45 days of the sale; and acquire the Replacement Property within 180 days of the sale as the second leg of the transaction through the use of the Qualified Intermediary.
Although this process is fairly simple, there are countless fact situations that can, and do, often arise which require reference to outside materials including commentaries written by exchange experts, subject matter handbooks, IRS published rulings or memos, and/or case law. The Exchanger’s extended team of professional advisers should be consulted to provide answers to these questions. Sometimes the exchange company staff, who deals with these nuanced situations on a daily basis, can provide materials to help the advisers reach a consensus on resolution.
Why Use a Drop & Swap in a 1031 Exchange?
One of the most common situations that requires additional attention occurs when the property being sold, the Relinquished Property, is owned in a limited liability company (LLC) or a partnership, but reference to “LLC” is used within this article for simplicity. Specifically, when one or more members of the LLC wish to enter into a tax deferred exchange while others wish to cash out at closing. The problem is that separate members have not held ownership in their personal capacity, rather the LLC, and to satisfy the “Same Taxpayer Rule” the same entity that sells the property must also purchase the new property.
The customary way to deal with this situation is to divide the entity by deeding a fractional interest as tenants-in-common (TIC) to the members in proportion to their ownership in the LLC. So, an interest is “dropped” to a member and when desired, the member does a “swap” or 1031 exchange with that TIC interest. The term coined for this structure is a “Drop & Swap.”
There are different ways to accomplish the “drop.” If two or more members wish to exchange and stay together in the Replacement Property and the non-exchanging members wish to cash out, with their consent, the exiting members can be dropped out of the LLC. There are benefits to being able to retain the LLC ownership by those members exchanging. Alternatively, if certain members each wish to complete their own 1031 exchange, those members might be dropped from the LLC by deed in order to sell as individuals or as single member LLCs.
There are certain tax risks involved, and considerations, with a “Drop & Swap” including:
- The dropped interest might not be deemed held long enough
- A mortgage lender might choose to exercise a “due on transfer clause” and declare a default
- If members want to do their separate exchanges, they cannot all retain the LLC ownership which can cause tension
- The LLC tax reporting is done on the IRS Form 1065, and the form asks the question “Did any member drop out of the partnership” during the tax year which can lead to scrutiny from the IRS regarding the “holding period” A co-ownership resulting from the dropping of one or more members could be considered by the IRS as a “de facto” partnership defeating the purpose of the “drop” in order to do an exchange
Rev. Proc 2002-22 outlines the requirements for acting as a true tenant-in-common versus being considered a “de facto” partnership.
Differing State Views on “Drop & Swaps”
As mentioned above, the U.S. states follow the federal position in the case of a valid 1031 exchange. However, it was also stated that some aspects of an exchange are not covered directly by the rules and regulations, which results in some states taking a different view on certain elements affecting the validity of a 1031 Exchange for property within their state, as well as for taxpaying residents of their state. Drop & Swaps are a case in point.
New York’s Stance of “Drop and Swaps” Related to 1031 Exchanges
A New York Division of Tax Appeals recently had an opportunity to rule on a last-minute Drop & Swap, i.e. no holding period established for the person receiving the fractional interest in the LLC and proceeding to the exchange (fa4435ae-9530-44b2-bbb3-9561229f79b2.pdf). Below are some excerpts from the very taxpayer favorable decision.
“….As discussed below, the record establishes that petitioners continuously held an interest in the CPW property for investment purposes, first through their investment interest in the property as members of Upwest and, then, albeit briefly, as tenants in common, and exchanged that interest for an interest in like-kind replacement property. The fact that the form of their ownership changed from owning the property through their partnership interests to owning it directly as tenants in common, and then exchanging their tenants in common interests in the CPW property for other investment property, does not invalidate nonrecognition treatment of the exchange (see Magneson v Commissioner, 753 F2d at 1494-95)…While petitioners held title to the CPW property as tenants in common only momentarily, the plain language of IRC (26 USC) § 1031 does not require ownership of the relinquished property for any particular period of time. Courts have found valid exchanges pursuant to IRC (26 USC) § 1031 in situations where title to exchanged property was held only briefly and only for the exchange (see e.g. Bolker v Commissioner; Alderson v Commissioner, 317 F2d 790 [9th Cir 1963]; Barker v Commissioner, 74 TC 555 [1980])…Thus, the Division’s interpretation that the “held for” language of IRC (26 USC) § 1031 requires that the property be held for a “minimum of a couple of month[s]” or other arbitrary duration is unreasonable and, accordingly, is rejected…”
As can be seen by the case law that is cited, there is support for this decision, albeit there is also contrary case law. And while this decision is viewed as helpful to the many people that frequently enter into “Drop & Swaps,” it should be kept in mind that this is only a state-level decision and does not necessarily bind other states to follow suit.
California’s View of “Drop & Swaps”
Other states, particularly California, are not as well-disposed in allowing a valid “Drop & Swap” where a limited holding period is present. California has taken the position that while the “dropping” entity may have “held the property for investment”, the party receiving the dropped interest cannot tack on the time as a member for holding purposes, the clock resets, and therefore the holding period requirements is deemed as not met. The California Franchise Tax Board (FTB) can take the position that the Drop & Swap is merely a “step transaction,” meaning a step to avoid the rule that a member (partner) cannot do his or her own exchange, it can only be done at the entity level. The FTB can also invoke the “Court Holding Doctrine” the term stemming from a 1945 U.S. Supreme Court holding. In essence the case held the substance of a transaction, rather than its form, should determine its tax consequences.
The “Drop & Swap” approach to 1031 exchanges provides a practical workaround when only some members of an LLC or partnership wish to defer taxes through a 1031 Exchange, while others prefer to cash out. However, its success depends heavily on timing, documentation, and—most importantly—the jurisdiction in which the transaction takes place. As illustrated by New York’s favorable treatment in recent case law, some states are willing to recognize even last-minute ownership changes as valid for 1031 purposes, provided the overall investment intent can be demonstrated. In contrast, states like California remain skeptical, scrutinizing such transactions under doctrines like the step transaction principle or the Court Holding Doctrine to challenge their legitimacy. Given these divergent interpretations, it is essential for Exchangers and their advisors to not only understand federal exchange rules but also evaluate the specific positions taken by state taxing authorities. When considering a Drop & Swap, consulting with experienced tax advisors and exchange professionals early in the process is critical to mitigate risks and ensure compliance across all applicable jurisdictions.