Drop and Swap (removing a partner from my 2 partner LLC)

[Russell Fugitt]

I have called several QI's and my lawyer, talked to my accountant.  Each call I make gets me a different answer.  

My 2 member LLC is going to sell the only property we own this month. My partner does not want to reinvest his half, I plan on reinvesting my half of the profits in another house.

One QI tells me that I can quit claim the title to 50/50 split between the LLC and my partner. Other QI's mention that the IRS will probably disallow the exchange because there is a holding period that will not be met if I transfer title before getting the property under contract.

I have heard many different opinions and am almost willing to pay the 20K in taxes just to be sure that I don't have a problem.  Has anyone on here had success  (or failure) with a drop and swap removing a partner shortly before a sale?

[Bill Exeter]

Hi Russell,

The one QI that suggested you deed the property out of the LLC into the individual partners' names via a quit claim deed is asking you to take on too much risk. We generally refer to this as a "drop and swap" structure. This was a very popular solution years ago, but has become much more risky since 2008.

The issue is that the "real" taxpayer is the LLC, which as a two (2) person LLC is treated as a partnership for tax purposes. The two individual partners merely own partnership interests and do not own any real estate. The partnership actually owns the real estate.

One of the requirements in the 1031 Exchange world is that the taxpayer must have the intent to hold his/her/its relinquished property and replacement property for rental, investment or business use purposes. Deeding the property out of the LLC and into the individuals' names and then immediately selling and structuring a 1031 Exchange would likely be disqualified because the seller (the individual who just took title) never had the intent to hold the property for rental, investment or business use purposes. They acquired title from the partnership merely to structure a 1031 Exchange at the individual (partners) level instead of the true taxpayer (the partnership).

The IRS Form 1065 (Partnership Tax Return) was amended in 2008 and actually asks if you have dropped the property out of the partnership and then immediately sold and structured a 1031 Exchange during the last two income tax years. 

There are many variations/solutions that might work.  One solution outlined above requires that gain be specially allocated to the partner that is not exchanging.  Special tax allocations can be tricky and problematic.  I would consult with your legal AND tax advisors before completing any type of exchange here.