“Drop and Swap” – Tax-favorable management of the real estate of a dissolving LLC | Patton Sullivan Brodehl LLP
A common LLC problem:
LLC members are willing to opt out of the LLC and share their interests in the LLC real estate.
Some members may want to sell, receive money and recognize earnings for tax purposes.
Other members may want to trade under Section 1031 of the Internal Revenue Code on different properties and avoid the tax hit that would otherwise be triggered by a sale.
Normally, the LLC—as the sole title holder of the property—would either: (1) sell its property, collect the taxes, and distribute the net (after-tax) proceeds to the members; or (2) make a 1031 exchange of its property for other property owned by the LLC. But neither of these options are satisfactory for members who wish to dissolve the LLC and go their own way, but want to avoid making gains on the property through a sale.
(The same problem also arises in partnerships.)
The “deposit and exchange”.
How does a “Drop and Swap” work
In a “drop and swap”, the ownership of the LLC is transferred to the members as separate tenancy interests (TICs), which generally will not trigger taxes. This part is the “drop”.
Each holder of a TIC interest can then decide what to do with their interest. They can sell, receive the money and report the gain, or they can make their own exchange 1031 (the “Exchange”).
One area of uncertainty surrounding a “drop and swap” has been the “held for” requirement under the Internal Revenue Code. The length of time that the TIC interest must be held is not specified in the Code.
The California Franchise Tax Board (FTB) has aggressively challenged some of these trades when there is not enough time between “drop” and “exchange”.
The Office of Tax Appeals provides advice
Earlier this year, the California Office of Tax Appeals (OTA) issued a ruling — In the matter of the appeal of Sharon Mitchell — rejecting the FTB’s request for a rehearing in a case providing guidance for drop and swap transactions.
In the Mitchell In this case, the taxpayer (Sharon Mitchell) followed a surrender and exchange procedure for property originally held by a general partnership. Her interest in the partnership was converted to a TIC interest, and then when the property was sold, she exchanged her TIC interest for a similar property under Section 1031.
The FTB challenged the exchange and attempted to impose an immediate tax bill of over $60,000. The FTB disputed that the partnership alone negotiated and entered into the sale agreement with the buyer, and the partnership gave the TIC interest to Mitchell just days before the sale closed. The FTB argued that the true seller of the property was the partnership and therefore Mitchell’s 1031 exchange was invalid.
In a 2-1 decision, the OTA sided with Mitchell, concluding that she was the true owner and seller of his TIC interest, and therefore entitled to the tax benefits of his 1031 exchange.
The FTB demanded a rehearing, arguing that the decision went against the FTB’s long-standing critical views of “dropouts and trades”. But the OTA denied the request, leaving the decision in Mitchell’s favor intact.
The decision of the OTA in Mitchell is unprecedented and non-binding for federal income tax purposes. But the IRS has traditionally not been as aggressive toward drop and swaps as the California FTB. And the Mitchell seems to signal that the aggressive attitude of the FTB will subside.
While the Mitchell decision is generally in favor of the “dip and trade”, it is probably risky to assume that similar transactions (the “dip” occurring very soon after the sale) will always be maintained. Instead, the safest approach is to follow these industry tips:
- Convert the entity’s property interests into TIC interests as soon as possible, before taking steps to market or sell the property.
- ICT owners will probably want to form an ICT agreement to deal with expenses, profits, etc. Each TIC owner might also want to form their own LLC to hold their interests to limit their liability.
- Allow time to pass while holding ownership in the interests of TIC. This indicates an intention to hold as investment property rather than an intention to avoid taxes. There is no clear holding period, but many experts advise holding for at least one year or a tax filing period.