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Today we are joined by Matt Rappaport, Esq., an attorney who specializes in taxation as it relates to real estate corporations, partnerships, trusts, and estates. In this episode, we will discuss a 1031 exchange strategy called a drop and swap.
A section 1031 exchange is a tax benefit written into the IRC that only applies to real estate. This strategy allows investors to roll over the proceeds of sale of any given parcel of real estate into replacement real estate that meets the same use criteria. Those proceeds can be rolled over without tax. The tax would be deferred until the following property is sold.
Drop and Swap
A drop and swap accommodates real estate investments that have multiple investors to allow exit strategies in more than one form. Each investor can do what he or she wants to do upon exit. For a traditional 1031 exchange in a partnership, investors must agree on what they will do with the proceeds because the owning entity will need to execute the exchange.
A drop and swap allows partners to drop their interest from the partnership into their own hands so that each partner can do a 1031 exchange, cash out, or whatever see fit.
You can't simply change the deed - you must put together a compliant conversion in order for the tax authorities to respect your move. This requires several steps, such as drawing up agreements, ensuring the owning entity is properly liquidated, and interfacing with the lender. Moving the debt from the entity to the individual parters can be difficult as well as lenders may be hesitant to allow change. If any of these elements is not met, tax authorities could seek to invalidate the entire exchange.
Ideally, a drop and swap would occur as close to closing as possible. The longer you wait, the more of a rush you'll be in to get signatures and settle on the economics of any more advanced distribution structures, like a waterfall.
Working with Lenders
You can't bat .1000 with lenders - sometimes they irrationally don't let you do what you'd like to do. You'll strike out with lenders sometimes. Ideally, the legal team immediately speaks directly with the lenders to explain exactly what will happen and help them see the light that making this move won't put anyone in any compromising positions. Occasionally, lenders will ask for additional accommodations in the deal. Sometimes these accommodations are certainly appropriate. In the case that the lenders says no, the deal is usually dead. You can't justify the deal without that safety, it's a larger audit risk. Lenders are a key piece in reducing any tax problems.
If real estate is owned in a corporation, the liquidation is a taxable event, which effectively eliminates the benefits of a drop and swap. If the value of the property is not high enough to justify the legal and other fees, a drop and swap is not beneficial either.
The cost of a drop and swap could range 25-30K in fees - tax, legal, advisory, lending. Usually the sponsor bears most of the cost. In a multi-investor scenario, each investor will have someone different representing their interest to reduce conflict.
On the buy-side, when trying to get 1031 capital into a transaction, the 1031 investors come into ownership via a Tenancy In Common agreement. The TIC interest could be rolled into LP interest at some point. 1031 investors will come into the LP via the TIC agreement. Everyone who is a TIC makes their contributions and takes back an LP interest on normal terms. All investors make a contribution of their interests into the LP, uniting all funds in the LP, and the investment will continue as normal. This is executed by a sponsor who is a non-member manager of a single-member LLC. The member of the LLC is the 1031 investor.
Calculating Ongoing Sponsor Asset Management Fee
Net income can't be used to calculate this because the sponsor is outside of the entity. However, the fees can be calculated based on gross income, not net income. It's typically not a great idea to get too creative, as you're exposed to more risk.