“Drop and Swap” is a term used to describe the process of dropping out of a partnership or membership interest of a limited liability company (LLC) into an ownership interest in investment real estate and then exchange or swap for new investment real estate.  The objective is to get into a position that allows you to exchange your real estate into new real estate and defer the taxes due on your gains.  There are pros and cons of a drop and swap and several variations all of which can be complicated, but a drop and swap is a valuable planning strategy to hang onto your hard earned gains.

Partnership or LLC is the owner

When multiple people come together to buy real estate, it is very common for them to form a partnership or a limited liability company (LLC) to hold the title to the property.  This form of ownership typically has its own tax identification number and files its own tax return. In most cases the income and expenses are distributed to the owners of the partnership on an IRS form K-1. Many people have the mistaken understanding that they own real estate when, in fact, they own an interest in an entity which owns the real estate.

1031 exchange

When it is time to sell the real estate and the real estate has gain, Uncle Sam and Aunt NC want a percentage of the gain. Section 1031 of the tax code allows the owner of property to exchange/swap for new replacement property and defer paying the taxes. The process defined in Treasury Regulation 1.1031, has very specific steps and timing parameters to accomplish an exchange properly. If a partnership or LLC own the real estate, the partnership or LLC can do an exchange, as it is a tax entity, filing a tax return under its own tax ID number. The individual partners or members cannot exchange their interests; the code is very clear on this issue (IRC §1031(a)(2)(D)).
It is very common that not everyone in the partnership wants to remain in the partnership and buy new replacement property(ies). Typically each member wants to go in their own direction. Some don’t want to pay taxes, and others are willing to do so.

Plan for the eventual sale and don’t wait to restructure

The language of the 1031 law says you can exchange property that was held for investment or business purpose for new investment or business replacement property to be held. The only way to defer taxes is to actually own the real estate and exchange for new real estate. The “Drop and Swap” strategy is to drop out of the partnership into a percentage ownership interest in the real estate. As an example if three people are equal members of an LLC which owns a rental beach house, the drop and swap strategy would have them terminate the LLC, file a final tax return for the LLC, and distribute the ownership of the real estate to the members. This would be changing the title of the rental beach house to reflect three individual tenants-in-common owners. The tenant-in-common owners should then have a tenant-in-common agreement reflecting how the property should be managed – Similar to a partnership agreement, but for tax purposes, not a partnership.
The terms “held” and “hold” in the law do not define a time period, but define intent. A taxpayer doing an exchange must have had the intent to hold the property. Time is one of many ways to prove intent. If you hold a property for a period of a year, then it is fairly clear your intent was to hold an investment property.
When planning for an eventual sale, the drop and swap objective is to get out of the partnership or LLC and into an actual ownership of the real estate so that you have the opportunity to do an exchange on your own interest.

Advice from the 1031 industry

The advice from the 1031 industry on a drop and swap has several steps.

• Drop out of the entity as soon as you can and into individual ownership long before showing any intent to sell. When you put the property on the market to sell, you have tipped your hand you intend to sell. Do not mix the two business decisions, dropping into individual ownership and selling together. If you mix the two decisions together, the IRS could easily argue your intent was to take a series of steps to avoid taxes.
• When you drop all owners into individual ownership, dissolving the partnership, or LLC, file a final tax return.
• Put some time on your ownership of the real estate, proving your (and your tax ID number) intent is to hold an investment property.
• If you want liability protection, each owner could own their individual real estate interest in their own single member LLC.
• Set up a co-ownership agreement with the other owners. Share expenses, profits, etc. IRS Revenue procedure 2002-22 is a good guide on the critical components.
• Be aware of a couple of questions on the partnership tax return Form 1065. Questions 13 and 14 on Schedule B ask if there was any drop and swap activity.

There are plenty of variations, and each situation is a little different. Owning property in a partnership and making decisions together can be like herding cats.
“Drop and Swap” is an important strategy to get into position to exchange real estate and defer taxes. Any time you are changing from one form of ownership to another, it is important to get good legal and tax help. Don’t do this on your own. Making yourself aware of the planning opportunity is the first step to keeping your investment dollars at work.

Now the 2012 IRS Instructions for the Form 1099-MISC reinforce the correction and have been published. They read as follows:  “The requirement described in the 2011 instructions for persons receiving rental income from real estate to report payments for certain rental property expenses on Form 1099-MISC was repealed by Congress. You do not have to report those payments on Form 1099-MISC.”

 A trade or business, like a Real Estate company or Property Management firm, is still required to submit Form 1099-MISC to support expenses. However, there are many exceptions to the rules. It is recommended that businesses responsible check the 2012 Form 1099-MISC Instructions. Especially for payments made to real estate agents, corporations and by credit card.

If you need help filing out he IRS From 8824, our guide will help. http://www.1031.us/8824/IRS8824.htm

Since this is only a 2 month bill – who knows what we will get at the end of February.

50% bonus depreciation will exist for certain personal property for 2012, as well as section 179 expense up to $500,000.

For those companies who took advantage of 100% bonus depreciation in 2011, they have to realize when they sell the equipment, it will have a very low, close to zero basis.    If you have a zero basis and sell the equipment for more than zero (hopefully) – Uncle Sam wants a pay back of the depreciation taken in 2011.  To avoid triggering taxes on personal property being sold, to save taxes and  improve cash flow, consider doing a 1031 like-kind exchange.  Realty Exchange Corporation has been exclusively in the IRC 1031 business since 1990 and serves as the Qualified Intermediary for both real estate and personal property equipment exchanges. Give us a call at 1-800-795-0769 to get the all the answers to any and all of your exchange questions.

http://www.1031.us/8824/IRS8824.htm

Special rules are provided for 1031 exchanges when there is a Federal Declared Disaster.  Go to Section 17 of “Revenue Procedure 2007-34” (http://www.irs.gov/irb/2007-34_IRB/ar13.html#d0e2854)  to learn the qualifications and rules for a 1031 exchanger to extend his 45 Day ID and 180 day exchange period dates.

The real estate and accounting industry fought a hard legislative battle in early 2011 to have 2011 rental property expenses excluded from Form 1099 MISC reporting by landlords. The 2011 IRS instructions for Form 1099 MISC did not pick up this legislative change, but IRS did publish the following notice of importance to all landlords.
“Legislative Change Affecting 2011 Instructions for Form 1099-MISC ”
http://www.irs.gov/formspubs/article/0,,id=239708,00.html    

Section 3 of Public Law 112-9 repealed section 6041(h) of the Internal Revenue Code, which would have required the reporting on Form 1099-MISC of rental property expense payments made after December 31, 2010  http://www.gpo.gov/fdsys/pkg/PLAW-112publ9/pdf/PLAW-112publ9.pdf.

Therefore, in the 2011 Instructions for Form 1099-MISC, please disregard:
•    Treatment of rental property expense payments under What’s New on page 1,
•    The second paragraph under Trade or business reporting only on page 1, and
•    Rental property expense payments on page 3.

IRS has published the Form 1099 MISC Instructions here: http://www.irs.gov/pub/irs-pdf/i1099msc.pdf

We have distributed since 1991 and put on our web site www.1031.us the workbook by Ed Horan on “Reporting the Like-Kind Exchange of Real Estate Using IRS Form 8824”.  http://www.1031.us/8824/IRS8824.htm

The 8824 Workbook is written and made available because form is very complicated and uses terms most exchangers are not familiar with. The 8824 Workbook for 2011 returns should be out by early December 2010. We will announce its availability on this Blog site.

While its publisher is not engaged in rendering legal or accounting service every effort is made to insure the guidance is in agreement with the IRS Form 8824 instructions.

IRS Revenue Procedure:  http://www.irs.gov/pub/irs-drop/rp-11-41.pdf
IRS notice:  http://www.irs.gov/pub/irs-drop/n-11-66.pdf

If the “adjusted basis” is less than what the property is sold for, then we have a “total gain”. Only if the adjusted “tax basis” is more than what we sell the property for does Uncle Sam consider we have a true loss. Most often the lower “adjusted basis” is the result of depreciation we have taken or could have taken. As mentioned, it is important that we know the “adjusted basis” of our property before we make any decisions. As the term implies, over time you adjust the basis in a property. When you purchase a property you have a starting basis which is figured by taking the purchase cost of the property and adding purchase expenses. As you add depreciable improvements, you adjust your basis up. If you own an improved property, you take a depreciation deduction every year, which lowers your basis. All of these adjustments, up for improvements and down for depreciation, give you your “adjusted basis”.
By subtracting this “adjusted basis” from the selling price we hope to receive, we have the projected “total gain”. The “total gain” will be taxed at different rates. The profit will be taxed at the capital gain rate (15%) if you have owned the investment more than a year. The “recaptured depreciation” is taxed at a flat rate of 25%. The amount of taxes due from “1250 recaptured depreciation” can be significant.

Let’s illustrate with a simple example. We bought a beach rental for $500,000 years ago. We have not done any depreciable improvements, though we have had lots of trips to Home Depot for operating expenses over the years. We have taken $100,000 in depreciation. Our adjusted basis is $400,000. During the boom years we saw our property value rise to $800,000 and sometime wished we had sold. Now we have an offer for $450,000. That seems like a loss, but our adjusted basis is $400,000. We have a gain of $50,000. This gain comes from the depreciation taken and will be taxed at 25%. Since the property is in NC, NC wants to be paid, too, and will apply the state income tax rate to the $50,000 gain as well.

So while we feel that we are selling the property at a loss, Uncle Sam and Aunt NC says, “No, you owe us tax money on the ’total gain‘ if you sell.” However, if you do a 1031 exchange, all the total gain, including the tax on recaptured depreciation, will be deferred.

If we exchange a property with a true loss, then the loss amount is added to the basis of the replacement property. A simple example would be if we had a vacation area lot that cost us $200,000 that we sold for $100,000 and exchanged for a $100,000 lot close to our home. We would have a $100,000 loss in the eyes of the IRS and would add our loss to the new basis of our replacement property. Because of the exchange, the new lot would have a starting basis of $200,000, even though we only paid $100,000 for the lot.

Of course, there are/may be other factors which will impact your tax situation, such as suspended losses on the property which may offset some of your gain, so be sure to consult with your tax adviser. Knowing your adjusted basis is an important step to determine if you truly have a loss and whether a 1031 exchange would be beneficial or not.