Drop-and-Swap Case Study: One Member Cashes Out, Second Does a 1031 Exchange
Our 1031 exchange experts are frequently asked how members in an LLC or partnership can choose different paths in a real estate transaction. For example, what if one wants to cash out of the investment property entirely and the other wants to reinvest their proceeds and defer taxes by executing a 1031 exchange?
A version of drop-and-swap can be used to address this situation.
The Situation
John Rosen and Mary Link were college friends. After graduation, they decided to invest in real estate together, pooling their money. They formed JRML LLC, and shortly afterward, acquired their first rental property – an apartment building in Pittsburgh, PA – that cost them $310,000.
Over the next 30 years, they maintained the property well, and it brought the two friends significant cash flow, but Mary recently decided she no longer wanted to own the property; instead, she would like to use her share of the sale proceeds to retire. However, John wants to continue investing in real estate. After consulting a local a real estate agent John and Mary learn that they can sell the property for $1.6 million.
The Problem
John quickly realizes that the sale of the apartment building would result in them owing capital gains taxes on $1,290,000 ($1,600,000 minus their initial $310,000 investment), plus depreciation recapture tax on $310,000. Taxes on the gain would be $258,000, plus $85,000 in additional depreciation recapture tax, as well as state taxes (3.07% tax rate of PA) of roughly $39,603, and net investment income tax of $49,020 at a rate of 3.8%.
In other words, the $1.29 million profit would be reduced by at least $431,623 due to associated taxes. John is personally not willing to incur that taxable event, so they need a different solution than an outright sale.
The Solution
After consulting with tax professionals, John and Mary set up a variation of the drop-and-swap strategy. Mary will withdraw from the LLC according to state laws. In exchange for her 50% stake in JRML LLC, she will become a 50% tenant in common owner of the property, owning a share alongside JRML LLC.
At the same time that Mary withdraws from the LLC, John’s brother, Robert, will become a 1% JRML LLC member, allowing its partnership tax status to remain intact because the entity will continue to have multiple members. The LLC will sell the Pittsburgh duplex, and Mary will get her 50% share of the proceeds in a taxable event to her only.
At the end of the year, the LLC’s CPA will issue documents that allow Mary to recognize her fair share of the depreciation recapture and capital gains. The financial results for Mary will be no different than if she remained in the LLC and the property was sold without an exchange.
John consulted with additional professionals and learned that JRML LLC would need to identify a Qualified Intermediary (QI) to help facilitate his involvement in the 1031 exchange transaction and successfully defer taxes. The QI requirement is necessary as neither John nor the LLC can be in possession of the sale’s proceeds at any time during the exchange. The QI will handle the preparation of all required exchange documents and hold onto the LLC’s portion of the proceeds from the sale.
After the sale, JRML LLC will have 45 days to identify an appropriate replacement property or properties. Using the exchange proceeds held by the QI, the LLC will complete the acquisition of their new property or properties worth at least $800,000, exchanging equal to or up from their share of the original property and maximizing the value of the 1031 exchange.
The Result
Mary was able to cash out of the original investment property, pay all the required taxes, and retire to Florida. John and Robert, as the two members of JRML LLC, continue to own investment property in the Pittsburgh area.
John was able to defer the taxes from selling the original investment property by using a 1031 exchange. Those taxes will remain deferred until John completes a real estate transaction without using a 1031 exchange.
Taxpayers are encouraged to discuss their plans with their legal and tax advisors before they move forward with the sale of an investment or business-use property, and they must engage the services of a QI as part of a real estate transaction that includes a 1031 exchange.