When real property is held by a partnership or limited liability company, often disagreements can arise among the partners as to how to handle net proceeds when the property is sold. Some investors want to conduct a 1031 exchange while others simply want to sell for cash.
When competing interests are in play, how can everyone be satisfied? One answer is what is known as a “drop and swap.”
In such a transaction, before the exchange the property ownership title is changed to reflect individual partner names and their partitioned interests rather than the partnership or LLC itself. This title change is the “drop.” Thereafter, the exchange occurs and some members defer their capital gains tax while others cash out and pay taxes.
While on its face it all sounds simple, the reality is the IRS is wary of this “drop and swap” strategy and carefully scrutinizes these transactions to determine if the “held for” requirement has been met. From the IRS’s point-of-view, when the title is changed from the partnership to the individual members, the clock for the holding period is reset to zero. This often catches unwary “droppers and swappers” out and jeopardizes the validity of the entire exchange.