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When a multi-member LLC contemplates selling a property and wants to do a 1031 exchange, sometimes one or more members may either want to invest in a different 1031-qualified replacement property or to discontinue their real estate investment, take their proceeds and pay their taxes. If other members of the LLC want to do a 1031 exchange, a drop and swap must to be utilized to change the ownership interest to allow one or more members to go their separate way and to allow others to do a 1031 exchange.
There are several specific steps the LLC must take to accomplish a drop and swap so that it will qualify as a 1031 exchange. The Members must terminate the LLC entity and take title as tenants in common as soon as possible when contemplating a sale of the property. Because marketing the property for sale starts the process of the LLC being the seller, the drop and swap should be accomplished before marketing begins.
After the LLC members have been dropped into a tenant-in-common ownership, they need a Tenant In Common Agreement specifying how the property will be managed to qualify each owner for 1031 treatment. To provide liability protection, each owner can set up a single member LLC to own their real estate interest.
The LLC would file a final tax return as of the date of conversion and the Members would report their pro-rata share of the rental activity on their individual tax return.
The IRS has not formerly approved this technique. Properly executing a drop and swap requires early planning with a tax attorney experienced in 1031 exchanges to provide the best opportunity for this transaction to qualify for 1031 treatment.