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Issue  244  Article  394
Published:  4/1/2018

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Section 1031, Holding Requirements for Drop/Swap and Swap/Drop Deals
Chris Burti, President, Statewide Title Exchange Corporation

Part of the 1031 XChange Index - Originally Published 10/31/2008 at STEC


This article was revised in 2015 as the previous proposals are now in effect.

Strategies used to structure Internal Revenue Code Section 1031 exchanges often become more complex when the exchanges involve property owned by partnerships, limited liability companies and closely held corporations. Investors cannot exchange interests held in such business entities and also defer recognition of gain or loss under Section 1031. Effective for transfers after March 31, 1984, the Tax Reform Act added partnership interests as non-qualified property for deferred treatment under IRC Section 1031. Yet, the entity itself can make an exchange of its qualified property and like any other taxpayer it will not have to pay capital gains taxes or recapture depreciation as a result. For example, if an entity owns an office building, the entity can exchange that office building under Section 1031 for another office building, or an apartment complex, or any other qualified "like-kind" property.

Dissolution of a closely held business and distribution of its assets after an exchange of any of its assets is an exit strategy referred to as a "swap and drop." If two parties own an entity that owns a single property worth $100,000, that entity may trade it for two properties worth $50,000 each (the swap). Those properties would then be matched with the ownership interest of the partners and this matching would subsequently allow for an easier dissolution of the entity (the drop).

There are occasions when it makes financial sense to split up or liquidate an entity and subsequently exchange the real property assets held by the entity to take advantage of the tax deferral benefits of Section 1031. In a "drop and swap" transaction, an entity first distributes assets to the partner(s) who want to cash out of the entity (the drop), and then these partners exchange the assets, as individual owners, under Section 1031 (the swap). For example, the partners may have developed different investment goals or perhaps they no longer desire to work together. In such cases, they may want to exchange out of the entity property, but each investor wants to invest their share of the proceeds independently. Under IRC Section 731(a) and (b), a distribution liquidating a partner's interest is generally tax-free to both the partner and the partnership (with exception for distributed cash, receivables and inventory exceeding the partner's adjusted basis). Subsequently, the entity will be liquidated and the entity's entire real property assets distributed individually to each partner. In some instances, one or more of the partners may opt out of the enterprise and in a liquidation of their interest, receive a distributive share of the assets individually or as an undivided interest in common with the entity rather than complete a dissolution of the entity.

One problem with structuring such transactions so as to qualify for favorable treatment under Internal Revenue Code Section 1031 is that the Code requires that the properties exchanged must be held for productive use in a trade or business or for investment. In the case of the transactions we've described, the holding period is very brief which, arguably, gives rise to the question of whether they have been held long enough to show the requisite intention to hold the property for the qualified purposes. The penultimate question may be how long must the property be held after a swap and drop or a drop and swap to qualify. Unfortunately, the Internal Revenue Code, the IRS, nor the courts have provided much certainty in this area.

We can look to Dealer Property issues for a start in analyzing the holding period issue. Stock in trade, inventory, or property that is primarily held for sale is disqualified from exchange treatment under Section 1031 if held for sale to customers in the ordinary course of the taxpayer's business. Real property held for sale by developers and real estate dealers is likewise not qualified property under Section 1031 and is referred to as dealer property. In determining who is a dealer with respect to a specific real estate transfer, the IRS looks at the facts and circumstances of each case and makes its determination on a property-by-property basis. The reason for this is that someone whose primary business is being a dealer may do a Section 1031 exchange with respect to property that actually qualifies as having been held for the required purposes. There is no clear-cut definition of dealer property, but the IRS tends to focus on the following issues: what is the taxpayer's primary business; what is the percentage real estate sales of the taxpayer's total income; how many property sales has the taxpayer transacted in the tax year; why was the property acquired and/or transferred; how long was the property held; what kind of development activity has the taxpayer been involved with on the property; and did the property have income-producing potential?

It is also important to recognize that you do not have to be primarily in the business of buying and selling real estate for your property to be treated as dealer property by the IRS. As an example, when a buyer of a taxpayer's Relinquished Property requires the taxpayer to preliminarily undertake subdivision approval activities or preliminary development work for the buyer's ultimate development of the property, the taxpayer could be considered as being in business with the buyer, and then the IRS could disqualify the exchange by characterizing it as a sale of dealer property.

Similarly, Section 1031treatment is not available for real estate investors who "flip" properties regularly. "Flipping" is the practice of buying real estate and then quickly reselling it (with or without new improvements) at a profit. This property is not eligible because it is held for resale and not for productive use in a trade or business or for investment. The taxpayer must remain aware of the requirement that both the relinquished and the replacement properties be held for use in a trade or business or for investment rather than resale. If the IRS characterizes the property as being held by the taxpayer for the purpose of resale rather than use in a trade or business or for investment, then the property will be disqualified from the Section 1031 exchange process unless the taxpayer can prove otherwise.

For tax purposes, a taxpayer can recharacterize property that does not ordinarily qualify for favorable Section 1031 treatment by actually using it in a trade or business or for the production of income. The IRS will look at how a taxpayer characterized that property on tax returns and whether the taxpayer has taken deductions for expenses, maintenance, and depreciation or has reported rental income on the property as part of its analysis of whether a particular property has been held for productive use in a trade or business or for investment. Although there is no written guidance on how long the property must be held for a qualifying use before it is recharacterized and can be exchanged, some tax professionals suggest six months, but that is arguably a bit arbitrary. Some advisors suggest holding it across at least one tax reporting period as a minimum. In Black v. Commissioner, 35 T.C. 90 (1960), the taxpayer received property and flipped it nine months later, with the Tax Court holding that this was not property held for investment. Others argue for a holding period of two years, reasoning the strict holding rules for related parties suggest a safe haven. Note that the IRS insists that it will examine each exchange on an individual basis, but has indicated that two years of business use is required to be sufficient in PLR 8429039. Where the disposition of the Replacement Property was required by events that were unrelated to the exchange, the IRS approved a holding period of less than six months in PLR 8126070.

These recharacterization issues might be applied to the drop and swap and swap and drop issues regarding holding requirements as well. The IRS has historically taken the position that property that is the subject of a tax-free exchange under Section 1031 may not be transferred immediately before or after that exchange. (see: Rev. Rul. 84-21, Rev. Rul. 77-337, Rev. Rul. 75-292, P.L.R. 822105). Older cases tend to be adverse to the taxpayer, and required clear evidence of holding period and qualified intent at the time the property was acquired. In Regals Realty Co. v. Commissioner, 43 B.T.A. 194 (1940), aff'd 127 F.2d 931 (2nd Cir. 1942), the property received in the 1031 exchange was immediately transferred to a new corporation and held to not meet the holding period requirement. In Revenue Ruling 75-292, the IRS ruled that a taxpayer transferring Replacement Property in a prearranged transaction to a corporation in exchange for stock under Internal Revenue Code Section 351, did not hold the Replacement Property for investment and the exchange did not qualify under Internal Revenue Code Section 1031.

In Magneson v. Commissioner, 81 T.C. 767 (1983), aff'd 753 F.2d 1490 (9th Cir. 1985), the court held that a swap and drop to a partnership worked. The Tax Court ruled that the prearranged transfer of an interest in real property to a partnership following a tax-free exchange satisfied the holding requirement of IRC Section 1031(a). The majority in the Circuit Court of Appeals reasoned that the contribution represented a continuation of the old investment and not a liquidation of that investment since the transfer to the partnership was not taxable under IRC Section 721.

Similarly, Bolker v. Commissioner, 81 T.C. 782 (1983), aff'd 760 F.2d 1039 (9th Cir. 1985) a Tax Court case appealed to the United States Court of Appeals for the Ninth circuit, dealt with a drop and swap and the Court held that they were permissible. Here corporate property received in liquidation was exchanged in a pre-arranged transaction for other like-kind property, the exchange qualified under Section 1031. The Commissioner argued unsuccessfully that because Bolker acquired the property with the intent, and almost immediate contractual obligation, to exchange it, Bolker never held the property for productive use in trade or business or for investment as required by section 1031(a). The Court relied on its decision in Magneson and determined that the fact that the tax-free transaction preceded rather than followed the like-kind exchange was not significant enough to warrant a different result. The Court examined all of the facts and circumstances of the negotiations and determined that the transaction was negotiated and consummated by the individual shareholder rather than the corporation, even though the agreement preceded distribution and liquidation of the corporation.

In Bolker the Court said that when "a taxpayer owns property which he does not intend to liquidate or to use for personal pursuits, he is "holding" that property "for productive use in trade or business or for investment" within the meaning of section 1031(a). Under this formulation, the intent to exchange property for like-kind property satisfies the holding requirement, because it is not an intent to liquidate the investment or to use it for personal pursuits." It may be significant that several recent letter rulings by the IRS have said that an exchange is not a sale which may give support to the position that a drop and swap should be less problematic than in the past.

There are potential problems with both of these cases. They dealt with facts preceding the effective date of, the Tax Reform Act of 1984 that added Internal Revenue Code Section 1031(a)(2)(D) which excludes exchanges of partnership interests. Though are important taxpayer favorable decisions, relying on them may be risky. Courts in other circuits are not bound by Ninth Circuit decisions even if Magneson has been cited favorably in two other Circuits. Even in the Ninth Circuit, a case involving different fact patterns could yield different results.

In Bonnie B. Maloney 93 T.C. 89, (1989) the Tax Court approved a swap and drop exchange structured by a corporation exchanging Relinquished Property for Replacement Property and then distributing the Replacement Property to its shareholders.  The IRS contended that the exchange failed because the corporation never intended to retain the Replacement Property for business or investment purposes but acquired it only to distribute to the shareholders. The Tax Court determined that the corporation held the Replacement Property for investment purposes regardless of its subsequent transfer of the Replacement Property to the shareholders. It is significant the corporation was liquidating completely subsequent to the exchange and this may suggest that partial liquidations might not be considered advisable for risk adverse taxpayers.

It is argued that these more recent cases should apply equally to transactions involving partnerships and LLC's, since for many purposes the Internal Revenue Code recognizes them as taxable entities. If they are recognized as a separate entity for purposes of tax-free exchanges under IRC Section 1031, in order to avoid the partnership being treated as the transferor, all negotiations and transactions must be carefully orchestrated to make clear that they are being conducted by a partner in an individual capacity. Under the language of Bolker, it would appear that a partner could negotiate an eventual transaction of property received in distribution prior to its actual receipt without violating the entity concept of Court Holding. Although Bolker and Magneson, in effect, overruled a couple of 1970's Revenue Rulings, the IRS has never revoked those Rulings. There is some speculation that the IRS may wish to keep these rulings alive in the event it chooses to actively challenge the drop transactions based upon a strict interpretation of Internal Revenue Code Section 1031(a)(2)(D ) combined with the application of the step transaction doctrine.

There are some cautionary determinations after Bolker and Magneson that must be evaluated when considering how to structure an entity drop transaction. In TAM 9818003, an exchange was disallowed when a partnership deeded the Relinquished Property directly to the transferee, but had the Replacement Property deeded directly to the partners. In 1997 the IRS issued PLR 9741017 which disallowed exchange treatment for two brothers who attempted to exchange their 1/2 undivided interest in a division of several tracts of land held title as tenants in common. They were deemed partners because they had filed partnership returns and the IRS determined that they had exchanged a partnership interest for the fee simple interest. Technical Advice Memorandum 9645005 (July 23, 1996) addressed a 1033 involuntary conversion in which a partnership distributed the Relinquished Property to the partners one day before its sale, and the partners received various replacement properties. The IRS held that the co-tenants had sold the Relinquished Property as conduits for the partnership and had never had the benefits or burdens of ownership.

The IRS has seemed to show more leniency when the taxpayer has not cashed out of the investment in the Relinquished Property in any significant way. In PLR 9751012 the IRS determined that acquiring Replacement Property by a taxpayer corporation, through the use of two wholly-owned LLCs, qualified for favorable Section 1031 treatment notwithstanding that the relinquished properties had been held by related predecessor corporations which were liquidated and merged into the taxpayer corporation. In PLR 200521002 the IRS ruled that Replacement Property acquired by a trust in a Section 1031 exchange may be distributed to the trust beneficiaries without affecting the tax deferral.

In July 2008 the IRS made changes to Form 1065, which is the form used by partnerships (as well as limited liability companies treated as partnerships for federal income tax purposes) to report income and losses. The revisions, which apply to 1031 exchanges, are found in questions 13 and 14 of Schedule B of the Form.  These changes suggest heightened IRS interest in distributions by a partnership of property to its partners immediately before or after a 1031 tax deferred exchange. These distributions are referred to as "drop and swap" when they occur before the exchange and "swap and drops" for those occurring after.  The IRS has consistently maintained that "drop and swap" and "swap and drop" transactions fail to qualify as valid 1031 exchanges as we discussed above.   

The changes are as follows:

Question 13:  Check this box if, during the current or prior tax year, the partnership distributed any property received in a like-kind exchange or contributed such property to another entity (including a disregarded entity).

Question 14:  At any time during the tax year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property?


Question 13 looks to whether a partnership has completed an exchange and then distributed the property to its partners or distributed the property to another entity in a "swap and drop.  This applies to the tax year of the filing and the prior year. Question 14 looks to whether a partnership has distributed an undivided interest in the property to one or more partners in a partial or complete liquidation of that partner's interest which might be a precursor to a "drop and swap" for a subsequent 1031 exchange.

The likely purpose of these changes is to track the distribution/contribution activities of partnerships or their partners engaging in 1031 exchanges.  How the Service intends to use this information is not yet clear, but there are holding period implications for a 1031 exchange.  One pitfall may be increased audit risk by the IRS for partners of a partnership that indicates on the forms that they have engaged in such transactions.


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