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Drop and Swap 1031 – A Comprehensive Guide for 2023

November 6, 2023

A 1031 exchange, also known as a like-kind exchange, is a powerful tax deferral strategy that allows real estate investors to defer capital gains taxes when selling one investment property and acquiring another of equal or greater value. However, advanced 1031 exchange strategies like the drop and swap usually require appropriate knowledge and expert guidance to maximize the tax-deferred exchange.

In this comprehensive guide, we’ll cover the basics of the drop and swap 1031, how it differs from the standard 1031 exchange, the step-by-step approach to a successful drop and swap transaction, and other essential things you need to know.

Kindly note that the information provided here is for informational purposes only and should not be considered as legal or financial advice. Always consult with a qualified tax or legal professional before engaging in any 1031 exchange or related transaction.

If you’re looking for an experienced Qualified Intermediary to facilitate a smooth tax-deferred exchange for you, book a free consultation with our experts at Universal Pacific 1031 Exchange to start your exchange.

Overview of The Drop and Swap Strategy

The drop and swap strategy works somewhat differently from the traditional 1031 exchange. Here, an investor’s goal is to swap their real estate partnership interests for direct ownership of a replacement property without paying capital gains tax. Typically, the partnership interest involves an indirect ownership of a real estate asset.

In the “drop” part of the exchange, the investor transfers the real estate asset into a new entity or structure owned by the investor, such as a limited liability company (LLC). This means that the investor now has direct ownership of the real asset.

In the “swap” part, the investor exchanges their direct ownership of the asset with another investment property in a standard 1031 exchange. Hence, they use direct ownership as the relinquished property in the exchange.

Benefits of 1031 Exchanges

Benefits of 1031 Exchanges

Unlike the traditional buying and selling of investment properties, there are various benefits of the 1031 exchange that make it an appealing strategy to investors. These benefits include:

Tax Deferral

1031 exchanges allow investors to keep more of their capital working for them by postponing capital gains taxes. This makes for potential growth in portfolio worth.

Portfolio Diversification

Exchanging properties without having to pay taxes provides a good avenue to explore different types of properties. You can also leverage the tax deferral to invest in different locations to suit your investment goals without worrying about tax implications.

Estate Planning

When an investor passes away, their heirs receive a stepped-up basis for the replacement property, potentially eliminating the deferred capital gains tax altogether. This can be a valuable estate planning tool.

Risk Mitigation

With like-kind exchanges, you can swap high-risk or underperforming investment properties for lower-risk or high-performing properties, thus minimizing investment risks.

Potential Risks of 1031 Exchanges

Potential Risks of 1031 Exchanges

Strict Rules

1031 exchanges come with strict rules and timelines. Failure to meet these requirements can result in the disqualification of the exchange and the inability to defer capital gains taxes.

Lack of Liquidity

Real estate investors must reinvest the proceeds in another property, which may not be suitable if they require cash or want to exit the real estate market.

Market Conditions

Market conditions can change between the sale of the old property and the purchase of the new one, potentially affecting the desirability and pricing of the replacement property.

Differences Between Drop and Swap 1031 and a Standard 1031 Exchange

Drop and Swap is often used when an investor wants to convert a partnership property, such as shares in a real estate investment trust (REIT), into direct ownership of a property before engaging in a 1031 exchange. 

In a regular 1031 exchange, an investor sells the relinquished property and directly invests the sales proceeds into acquiring a suitable, qualified replacement property(ies). 

Hence, the key difference between a standard 1031 exchange and a Drop and Swap is the initial step of dropping the partnership interests into a new entity. However, note that the Drop and Swap processes may introduce additional legal and tax considerations compared to a straightforward property-to-property exchange.

Given the complexities of the Drop and Swap strategy, it’s important to consult with experienced professionals such as tax attorneys, qualified intermediaries, and real estate advisors to ensure compliance with the IRS, maximize the benefits of the strategy, and get proper guidance throughout the process.

Step-by-Step Guide to Drop and Swap 1031

Step-by-Step Guide to Drop and Swap 1031

Step 1: The “Drop”

1. Legal Entity Formation

The investor creates a new legal entity to hold the real estate asset, usually a limited liability company that they own. It’s crucial to seek appropriate counsel from an attorney to ensure the entity formation complies with state laws and serves the intended tax and legal purposes.

2. Transfer of Ownership

The investor transfers the ownership of the asset from the partnership interest or ownership structure to the legal entity. You may need to draft and execute legal documents to carry out the transfer.

3. Tax Considerations

The ownership transfer is not a taxable event. You need to involve tax professionals to ensure that the transactions meet the IRS requirements to avoid immediate tax on capital gains.

Also, be careful of related party rules that may limit the ability to exchange property with related parties. Seek legal advice to navigate these rules.

4. Capital Contributions

Ensure that the investor contributes enough capital or assets to the new entity to justify the ownership of the real estate asset. The allocation of ownership in the new entity should reflect the investor’s percentage ownership interest. Consult with tax professionals to determine the appropriate amount and structure of contributions.

5. Timing

You need to be sure that the drop stage corresponds with the swap stage to align with the 45-day identification period and 180-day exchange period required for a 1031 exchange.

Step 2: The “Swap”

The Swap stage involves identifying and exchanging the property after the drop phase. Here’s a rundown of the “Swap” phase

1. Identify Potential Replacement Properties

Research and identify suitable replacement properties. Analyze the assets and choose the ones that align with your investment goals and budget. You must complete the identification within 45 days from the date you sold the relinquished property.

2. Obtain Contracts

Enter into contracts to acquire the replacement properties. This should be done promptly after identifying the properties to ensure they are under contract within the 45-day identification period.

3. Close on Replacement Property

Acquire the replacement property within the stipulated timeline of 180 days from the sale of the relinquished property.

Challenges and Potential Risks for Drop and Swap 1031

Challenges and Potential Risks for Drop and Swap 1031

Legal Complexities

There are many legal requirements involved in forming a new legal entity such as an LLC. Handling these processes wrongly may attract severe legal or tax consequences. So, you’ll have to ensure that the process complies with relevant IRS regulations and state laws. 

The company structure should also align with your investment goals. The entity must be created in compliance with state laws and IRS regulations, and its structure should align with the investor’s goals.

Ownership Transfer

The transfer of ownership from the partnership interest to the new entity requires legal documentation and may be subject to state-specific regulations. Consult with legal and tax professionals to ensure compliance throughout the exchange transactions.

Capital Requirements

Sometimes, it’s challenging to determine the right amount and structure of capital contributions to the new entity. Also, the IRS may scrutinize the capital contributions, potentially resulting in a delayed or complicated transaction. Seek guidance from accounting and tax professionals to adhere to the IRS requirements.

Timing Constraints

Meeting the 45-day identification period and 180-day exchange period for a 1031 exchange can be challenging. Investors need to act quickly and efficiently to identify and secure suitable replacement properties.

Operating Expenses

Most legal, tax, and accounting professionals charge fees for their services. These costs add up to reduce the overall financial benefits from the tax deferral.

Market Conditions

Market conditions can change between the “Drop” and “Swap” phases, potentially affecting the availability and pricing of replacement properties.

Importance of Seeking Expert Guidance

Importance of Seeking Expert Guidance

Given these complexities and the potential for costly errors, it is important to seek expert guidance when considering a Drop and Swap strategy. Here’s why:

Leverage Legal and Tax Expertise

Tax attorneys, accountants, and real estate advisors can provide specialized knowledge to structure the transaction correctly and ensure compliance with tax laws and IRS regulations.

Minimize Risk

It’s easier for experts to identify potential pitfalls, misinterpretations, or areas of non-compliance. This allows investors to take corrective actions and avoid negative consequences.

Maximizing Benefits

Minimizing potential risks and losses is a good way to maximize the benefits of Drop and Swap 1031. Beyond being careful, these professionals can also proffer solutions on how best to position your investments for maximum benefits.

Navigate Complex Legal Procedures

The legal procedures involved in forming new entities and transferring ownership are complex and subject to state laws. Legal guidance is crucial to ensure proper execution.

Timely Execution

Failure to adhere to the strict timelines for identifying and closing on replacement properties may disqualify your exchange for tax deferral. Experts can help ensure the process is executed efficiently and as early as possible.

Expert Tips For a Successful Drop and Swap 1031

Here are some expert tips and considerations from professionals in real estate and tax law regarding 1031 exchanges, including the Drop and Swap strategy.

1. Stay Up to Date with Current 1031 Exchange Rules

Tax laws and regulations can change, so you need to stay informed about these changes as soon as possible. Regularly consult with tax professionals and attorneys who specialize in real estate to ensure that your strategies align with the latest rules and requirements.

2. Adhere to the Strict Timelines

Be mindful of the strict timelines associated with 1031 exchanges, including the 45-day identification period and the 180-day exchange period. You need to meet these deadlines to avoid disqualification.

3. Keep Proper Documentation

Maintain proper records throughout the entire like-kind exchange process. This includes all correspondence, transaction documents, and financial records. Proper record-keeping is essential for IRS compliance and potential future audits.

4. Engage Qualified Intermediaries

It’s recommended to involve the services of a qualified intermediary (QI) who is experienced in the Drop and Swap exchange. They can provide essential guidance, ensure compliance with IRS rules, and facilitate the exchange process.

5. Due Diligence

Beyond the professional advice, it’s not out of place to conduct thorough research on the potential replacement property before you proceed with the Swap phase. Assess their suitability for your investment goals and consider factors like location, market conditions, financing, and the property’s operating expenses.

Conclusion

The Drop and Swap strategy within a 1031 exchange offers real estate investors significant advantages, such as tax deferral, increased control, and wealth accumulation potential. However, it comes with its share of complexities, including strict IRS rules, legal intricacies, and timing constraints. Hence you need to seek expert guidance from qualified professionals such as legal and tax professionals with specialized knowledge in 1031 exchanges. 

At Universal Pacific Exchange, our licensed CPA professionals are available to help facilitate your 1031 exchange needs and provide expert guidance for a successful exchange transaction. Book a free consultation with us today to start an exchange.

About The Author

Michael Bergman, CPA
Michael Bergman is a California licensed CPA and Real Estate Broker with over 32 years of experience in commercial real estate. Specializing in 1031 tax-deferred exchanges and financial oversight, his expertise is invaluable for complex real estate transactions. Michael’s unique blend of financial acumen and real estate knowledge positions him as a trusted advisor in the industry, offering sound advice and strategic insights for successful property management and investment.

Don’t let taxes hinder your property investment decisions. Connect with us today for a free, no-obligation 1031 exchange consultation. Let us help you navigate the process with ease.