“Drop and swap” ruling proves planning is key - by Patricia Flowers

Patricia Flowers, Investment Property Exchange Services

Qualified Intermediaries (QI) are usually called in to service sometime between the P&S agreement signing and the sale closing date…but is that really soon enough? Maybe not. A recent California tax ruling proves that consulting with the QI regarding the selling entity’s intentions for a 1031 Tax Deferred Exchange is more important than ever. When structuring an exchange, part of my initial assessment entails inquiring of the entity ownership and its plans going forward. Any entity can participate in an exchange, however, the taxpayer that sells must be the same that acquires replacement property. In cases where it is a partnership or multiple member LLC (reporting as a partnership), this vesting regulation becomes an important issue I always address.

If the entire partnership/LLC plans to sell and exchange, vesting is satisfied under §1031. Problems arise when “drop and swaps” occur. The partnership distributes the to-be relinquished property to the partners shortly before the sale (the drop). Those partners now become individuals owning the property as tenants-in-common, selling and/or exchanging (the swap) into replacement property separately.

These transactions have always been considered aggressive. To prove the point, recently the California State Board of Equalization (SBE) upheld the Franchise Tax Board and ruled against the taxpayers in In re Giurbino. A multiple member LLC had deeded property to the members a few days before the sale. Some of the members reported their share of the gain on their income tax returns; however the Giurbinos took the position they had completed a 1031 Exchange.

The SBE ruled that the LLC (not its members) was the seller of the property, concluding that at the time the property was deeded to the members of the LLC “the sale of the property was practically certain to be completed.” Accordingly, the members were essentially acting as agents for the LLC. Thankfully, most concerns can be resolved with advanced planning. IPX1031 can recommend a number of options to counsel regarding partnership/LLC issues.

Patricia Flowers is vice president for Investment Property Exchange Services, Inc. (IPX1031), Boston.