Section 1031 of the Internal Revenue Code, the 1031 exchange, has long been a favorable tax-deferral tool for commercial and investment real estate owners. The 1031 exchange allows for investors to potentially defer the capital gain and depreciation recapture that would be due upon the sale of their property/properties by reinvesting their proceeds into “like-kind” real estate.

When performing an exchange, exchangers must be wary of several rules or risk invalidating their deferral. One of those rules that is most commonly misunderstood, in my experience, is the “Same Taxpayer Rule.” The Same Taxpayer Rule states that the taxpayer who sells the relinquished property must be the taxpayer who purchases the replacement property. Typically, this means that if the seller is an individual, replacement property must be bought in the name of that same individual. If the seller is a partnership, replacement property must be bought in the name of that same partnership. The same is generally true for LLC’s, S-Corp’s, C-Corps, and myriad other ownership structures.

The Problem with Partnerships

Holding a property in a partnership can add an extra layer of complexity when seeking to perform a tax-deferred 1031 exchange. Occasionally a partnership has run its course and the investment goals of the partners no longer align. If one party wants to defer tax liability via exchange and another party wants to cash out and pay the tax, it can cause headaches. Because the partnership is seller and exchanger, the partnership must be the buyer of replacement property. This means separation is not possible for the partners. 

The “Drop and Swap” Solution

The “Drop and Swap” is a strategy that is often used in conjunction with the 1031 exchange to counteract the problem of partners disagreeing. As the name implies, there are two phases of this process:

1. The Drop: Prior to the sale, the partnership drops the property from the original partnership by liquidating the partnership and distributing tenant-in-common (TIC) interests to the individual partners.
2. The Swap: Once the ownership is structured as a tenants-in-common, everyone holds direct title to their portion of the real estate. Therefore, everyone is a separate seller and can perform their own exchange or choose to cash out their portion, if applicable, independent of the other members’ choices.

The DST and Partnerships

While the drop and swap may potentially be an effective strategy for those seeking a “divorce” from their partners, there are risks involved. The process itself has a chance to raise eyebrows within the IRS regarding the intent of the property and duration it is held, and the IRS has not released specific guidance on how long a property must be held as a TIC before performing a 1031 exchange.

The DST, or Delaware Statutory Trust, can be another strategy for those wishing to go their separate ways. The DST is a fractional ownership investment of institutional grade real-estate, which is seen as real property through the eyes of the IRS. Therefore, investors can choose to reinvest their 1031 exchange proceeds into a portfolio of fractional ownership DSTs giving them an opportunity for passive income that is diversified by asset class and geographical location.

Changing the ownership structure of a partnership within a DST can be as easy as calling your Fortitude Investment Group representative and signing a few documents. This allows for partners to avoid the potential questions that may arise from the IRS while doing a swap and drop. 

They can also choose to utilize their potential proceeds however they’d like once the DST is approaching a sale. The DST allows for ease of dividing as it is already fractionalized ownership. There is flexibility as well in allowing the partners to select exposure to deals they are comfortable with, allowing for an essential split even prior to investing. Passive investment in the DST also means no longer co-managing an asset, for those who are exiting a partnership on unfriendly terms. 

The most flexibility comes on the full cycle of the DST, where partners can choose to reinvest their potential proceeds into another passive investment with the DST, 1031 exchanging back out into the market, or cashing out their funds. Additionally, the 721 exchange may be used for increased optionality. 

Feel free to reach out to our team at Fortitude to learn more about the Drop and Swap and discuss the DST or other 1031 exchange strategies.  

Because investor situations and objectives vary this information is not intended to indicate that an investment is appropriate for or is being recommended to any individual investor.

This is for informational purposes only, does not constitute individual investment advice, and should not be relied upon as tax or legal advice. Please consult the appropriate professional regarding your individual circumstance.

There are material risks associated with investing in private placements, Delaware Statutory Trusts ("DSTs") and real estate securities including the potential loss of the entire investment principal, illiquidity, tenant vacancies impacting income and revenue, general and real estate market conditions, lack of operating history, interest rate risks, competition, including the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and investors should read the PPM carefully before investing paying special attention to the risk section.

Diversification does not guarantee a profit or protect against a loss in a declining market.  It is a method used to help manage investment risk. Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated.                                                                                 

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