"Drop and swap" transactions are increasingly common in real estate dealings, particularly within partnerships facing decisions about appreciated properties. In this process, a partnership distributes undivided tenant-in-common interests in the property to its partners. These partners then have the option to either exchange these interests for replacement real property under Section 1031 like-kind exchanges or opt for a cash sale.

Partnerships often grapple with dilemmas when holding appreciated real estate. Some partners may prefer an exchange of the property for new assets, while others seek to cash out and recognize the gain. While various solutions exist, such as full or partial Section 1031 exchanges, they might not always align with partnership allocation requirements or might be challenging to execute practically. The drop and swap process offers a seemingly straightforward solution to cater to partners who wish to exit the partnership's property swiftly.

However, despite its practicality and widespread use, there are lingering concerns about the technical compliance of these transactions. One significant concern revolves around the holding requirement under Section 1031. For a property to qualify for Section 1031 treatment, it must be held for productive use in a trade or business or for investment purposes. If there's an intent to dispose of the property immediately after acquisition, it might not qualify. This aspect of intent and the duration of holding the property pose challenges in determining compliance with Section 1031.

Additionally, there's a potential conflict with Section 1031(a)(2), which prohibits exchanges involving partnership interests. When a partnership distributes undivided interests in its property and partners engage in Section 1031 exchanges, there's a risk that the transaction might be considered an exchange of a partnership interest rather than the property itself. The ambiguity in defining partnerships under tax law further complicates the treatment of distributed interests.

To mitigate these concerns, advisors recommend delaying the swap after the drop, allowing time between these actions. However, the timeframe isn't the sole factor; the intent at the time of the transaction plays a crucial role. This delay aims to address potential issues related to the holding requirement and potential tax doctrines' application.

In conclusion, while drop and swap transactions offer a seemingly efficient way to handle partnership property disagreements, uncertainties surrounding their technical compliance persist. Tax authorities are beginning to scrutinize these transactions more closely, prompting partnerships to reconsider their strategies before engaging in such transactions. ALWAYS discuss these issues with your tax advisor.

To ensure compliance with requirements imposed by the IRS, we inform you that the information posted at this website does not contain anything that is intended as legal or tax advice, and that nothing herein can be relied upon as legal or tax advice. Further, the IRS wants us to let you know that nothing herein can be used for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any tax-related matter addressed herein. If assisting with your Section 1031 tax-deferred exchange, Fyntex cannot advise the owner concerning specific tax consequences or the advisability of a tax-deferred exchange for tax purposes. We recommend that anyone contemplating an exchange seek the advice of an accountant and/or attorney.

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Washington state law, RCW 19.310.040, requires an exchange facilitator to either maintain a fidelity bond in an amount of not less than one million dollars that protects clients against losses caused by criminal acts of the exchange facilitator, or to hold all client funds in a qualified escrow account or qualified trust that requires your consent for withdrawals. All exchange funds must be deposited in a separately identified account using your taxpayer identification number. You must receive written notification of how your exchange funds have been deposited. Your exchange facilitator is required to provide you with written directions of how to independently verify the deposit of the exchange funds. Exchange facilitation services are not regulated by any agency of the state of Washington or of the United States government. It is your responsibility to determine that your exchange funds will be held in a safe manner.

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