1031 Exchange vesting issues –Partnership Drop and Swap
Can a partner or member trade their share of a property interest upon sale? One of the most common questions asked of a qualified intermediary involves the situation in which one or more members or partners in a limited liability company (LLC) or partnership wish to execute a1031 exchange and others simply want to cash out. Because section 1031 provides that property must belike-kind to each other, there are several difficulties to structuring an exchange that allows members to go their separate ways.
The most common technique involves redeeming the member’s interest and is generally referred to as a “drop and swap.”A1031 tax exchange drop and swap can take place in several different ways. When most members wish to cash out, the taxpayer can transfer his membership interest back to the LLC in consideration of his receipt of a deed for a percentage fee interest in the property equivalent to his former membership interest. At that point, the taxpayer would own a tenant in common (TIC) interest in the relinquished property together with the LLC. At closing, each would provide their deed to the buyer, and the former member can direct his share of the net proceeds to a qualified intermediary. There are times when most members wish to complete an exchange, and one or more minority members want to cash out. The drop and swap can still be used in this instance by dropping applicable percentages of the property to the existing members. At the same time, the limited liability company completes an exchange at the LLC level, and the former members cash out and pay the taxes due.
Read more on the details on our blog: 1031 Drop and Swap out of a Partnership or LLC
When selling or purchasing an investment property in a 1031 exchange, certain selling expenses paid out of the sales or 1031 exchange proceeds will result in a taxable event for the exchanger. Routine selling expenses such as broker commissions or title closing fees will not create a tax liability. Operating expenses paid at closing from 1031 proceeds will generate a tax liability for the exchanger.
Allowable closing expenses include:
- Real estate broker’s commissions, finder, or referral fees
- Owner’s title insurance premiums
- Attorney or tax advisor fees related to the sale or the purchase of the property
- Closing agent fees (title, escrow, or attorney closing fees)
- Recording and filing fees, documentary, or transfer tax fee
Taxable Closing expenses include:
- Pro-rated rents
- Security deposits
- Utility payments
- Property taxes and insurance
- Association’s dues
- Repairs and maintenance costs
- Insurance premiums
- Loan acquisition fees
Learn more on how to reduce these taxable consequences: What are Valid 1031 Exchange Selling Expenses
Cash Out Refinance Before or After a 1031 Exchange?
Most taxpayers wish to defer tax in full when completing a 1031 exchange. One simple rule of thumb is that the taxpayer must trade “up or equal” in value to accomplish this. At times taxpayers wish to receive some cash out for various reasons. Any cash generated at the time of the sale that is not reinvested is referred to as “boot” and is fully taxable. There are a couple of possible ways to gain access to that cash while still receiving full tax deferral. When trying to generate some cash around the time of selling relinquished property, it may seem like a good idea to refinance right before an exchange. It would leave you with money in pocket, higher debt, and lower equity in the replacement property, all while deferring taxation. Except, the IRS does not look favorably upon these actions. It is, in a sense, cheating because by adding a few extra steps, the taxpayer can receive what would become exchange funds and still exchange a property, which is not allowed. Certain situations may lessen the IRS’ scrutiny of these actions. There is no bright-line safe harbor for this, but at the very least, if it is done somewhat before listing the property, that fact would be helpful. The other consideration that comes up a lot in IRS cases is independent business reasons for the refinance. Maybe the taxpayer’s business is having cash flow problems. Perhaps the property needs a new roof or other repairs.
In general, the more time elapses between any cash-out refinance, and the property’s eventual sale is in the taxpayer’s best interest. For those that would still like to exchange their property and receive cash, there is another option. The IRS does allow for refinancing on replacement properties. The American Bar Association Section on Taxation reviewed the issue. It concluded that once a taxpayer owns replacement property and refinances it, incurring a repayment obligation, that taxpayer is in no different position than anyone else owning property and refinancing it.
Seller Financing in a 1031 Exchange
In a 1031 exchange, there are methods to facilitate seller financing of the relinquished property sale without running afoul of the 1031 exchange rules. In a sale of real estate, it’s common for the seller, the taxpayer in a 1031 exchange, to receive money down from the buyer in the sale and carry a note for the additional sum due. The taxpayer facilitates financing for the buyer in this way to make the transaction happen. Sometimes this arrangement is entered into because both parties wish to close, but the buyer’s conventional financing takes longer than expected. Suppose the buyer can procure the funding from the institutional lender before the taxpayer closes on their replacement property. In that case, the note may simply be substituted for cash from the buyer’s loan. When this is not the case, and the taxpayer will not receive funds in the exchange account before the end of their 180-day exchange period, the solution is a note buyout. The taxpayer will advance funds of their own into the exchange account to “buy” their note. The funds can be personal cash that is readily available or a loan the taxpayer takes out. The buyout allows the taxpayer to receive fully tax-deferred payments in the future and still acquire their desired replacement property within their exchange window. Keep in mind that regulations prohibit the taxpayer from the “right to receive money or other property pursuant to the security or guaranty arrangement,” it is probably better to receive the cash into the account sometime before the purchase of the replacement property while assigning the note to the seller after all the replacement property has been acquired.