Partners in a partnership (or members in a LLC taxed as a partnership) sometimes have differing views on how to take proceeds from the sale of investment property. Some partners want to cash-out while others want to remain in the partnership and buy new replacement property (i.e., defer taxable gain by having the partnership complete a Section 1031 exchange). If the partnership takes some cash at the closing for distribution to partners wanting to cash-out and places the balance with a Section 1031 qualified intermediary, the partners wanting a 1031 exchange will likely be allocated taxable gain.

The desire to avoid taxable gain being allocated in this fashion sometimes gives rise to a transaction commonly referred to as a “drop and swap”. This describes the process of a partner dropping out of a partnership into a direct property ownership interest, then swapping it for new investment property. This generally involves the partnership distributing a tenancy-in-common interest in the relinquished property to the partner before the sale, hoping that this will allow the former partner to treat the transfer of the resulting tenancy-in-common interest as a separate transaction.

There can be a number of technical and practical problems to implementing a drop and swap transaction. 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 terms “held” and “hold” in the law do not define a time period but they define intent. A taxpayer doing an exchange must have had the intent to hold the property. Time is one of the many ways to prove intent     so whenever possible you want to plan for an eventual sale, not wait until it is about to happen.

There are two alternatives potentially available to avoiding the allocation of taxable gain to a partner wanting a 1031 exchange.

One option is for the partner to drop out of the entity and into actual ownership of the real estate long before showing any intent to sell. That gives the former partner the opportunity to do an exchange on his own interest. You want to do this early enough so the intent to hold for investment purposes is clear. Once property is put on the market for sale, you have already tipped your hand you intend to sell.

Another option is to convert the cash intended to go to cash-out partners into an installment note. This allows the partnership to avoid recognizing gain and allows all gain associated with the installment note amount to be allocated to those willing and planning to take it, namely the cash-out partners to whom the note is transferred in complete redemption of their interests in the partnership. So long as a valid installment note is received as “boot” in a partnership installment note transaction where the selling partnership also completes a Section 1031 exchange, the gain represented by the note is taxed only when principal payments on the note are received. This would be after the note is transferred to, and is held only by, the cash-out partners.