What If One Property Owner Wants a 1031 Exchange and the Other Wants Cash?

Owning investment real estate with partners can work well for decades until it is time to sell. One owner may want to take the cash and pay the tax. Another may want to complete a 1031 exchange. Someone else may want to remain invested in real estate but no longer wants the responsibilities of direct property ownership.

Different objectives do not necessarily mean everyone has to choose the same outcome. But whether each owner can pursue a separate strategy depends heavily on how the property is owned and which taxpayer is actually selling it.

That distinction should be addressed well before closing. Once a sale is underway, restructuring ownership to accommodate different tax objectives can become considerably more complicated.

When co-owners disagree about what should happen after a sale, the first question is not which replacement property to buy. It is who owns the property today and which taxpayer will actually be completing the transaction.

Start With How the Property Is Owned

Two properties can have identical ownership percentages but very different tax-planning options depending on their legal and tax structure.

If three individuals directly own a property as tenants-in-common, for example, each generally owns a separate undivided interest in the real estate. That can provide greater flexibility for one owner to sell and pursue a 1031 exchange while another receives cash, assuming the transaction is structured properly.

The situation is different when the property is owned by a partnership or an LLC taxed as a partnership. In that case, the entity owns the real estate and the individual partners own interests in the entity. Because partnership interests themselves generally do not qualify as replacement property under Section 1031, an individual partner cannot simply take their share of the sale proceeds from the partnership and independently treat it as their own real estate exchange.

Other entity structures can create still different considerations.

This is why the ownership structure needs to be understood before discussing the exchange strategy.

What Is a Drop-and-Swap?

When real estate is owned through a partnership or LLC taxed as a partnership and the owners want different outcomes, one strategy that may be considered is commonly called a “drop-and-swap.”

In simplified terms, the entity distributes interests in the underlying real estate to its owners before the sale. Instead of owning partnership interests, the former partners may then own undivided interests in the property directly, often as tenants-in-common.

If properly structured, an owner who wants liquidity may be able to sell their interest and receive cash, while another owner may sell their interest and pursue a 1031 exchange.

The concept sounds simple. The execution is not.

A 1031 exchange requires that property be held for investment or productive use in a trade or business. When ownership is restructured immediately before an anticipated sale, questions can arise about whether the required investment intent exists and whether the overall series of transactions will be respected.

There is no simple universal holding period that makes a drop-and-swap safe. Timing, documentation, negotiations with the buyer, the history of ownership, and the facts surrounding the transaction can all matter.

A drop-and-swap should not be viewed as paperwork completed immediately before closing. The earlier the owners identify their different objectives, the more opportunity their tax and legal advisors have to evaluate the structure properly.

One Owner Can Want Cash While Another Wants Tax Deferral

Assuming the owners are in a structure that allows them to sell separate interests, their paths can potentially diverge at the sale.

The owner who wants liquidity can receive the proceeds attributable to their interest and recognize the applicable tax consequences. An owner pursuing a 1031 exchange would generally need their proceeds directed to a qualified intermediary and would then follow the normal identification and replacement-property requirements.

That owner could potentially exchange into another directly owned property, one or more DSTs, or another qualifying replacement strategy depending on their objectives.

This can be particularly valuable when the owners are at different points financially. One may need cash for retirement or another investment. Another may have a large embedded gain and prefer continued tax deferral. A third may want to remain in real estate but move away from active management.

The goal is not to find one strategy everyone can tolerate. When possible, it is to determine whether the ownership structure can accommodate each person's objectives.

Entity Structure Can Limit the Options

Not every ownership structure provides the same flexibility.

Properties held through corporations, including S corporations, can present materially different tax considerations because the corporation owns the real estate rather than the individual shareholders. A shareholder generally cannot independently exchange a portion of corporate real estate simply because they economically own a percentage of the company.

Changing an entity structure shortly before a sale can itself create significant tax and legal consequences. That makes this an area where assumptions can become expensive.

If owners know they are likely to disagree about an eventual exit, the better time to address the issue is before a buyer appears and before a purchase agreement or closing date begins limiting the available choices.

How to Choose the Right Approach for Your Situation

Co-owners should begin by discussing what each person actually wants from the transaction.

Who wants cash? Who wants continued tax deferral? Who wants to remain in real estate? Who wants passive income rather than another actively managed property? And does anyone have liquidity, estate-planning, or other financial needs that should influence the decision?

Then the CPA and legal counsel can evaluate whether the existing ownership structure supports those different outcomes or whether advance planning should be considered.

The earlier those conversations occur, the more flexibility the owners are likely to have.

Conclusion

Co-owners of investment real estate do not always have the same objectives when it is time to sell. One may want cash while another wants to continue deferring taxes through a 1031 exchange.

In some ownership structures, accommodating those different objectives can be relatively straightforward. In others, particularly when real estate is owned inside a partnership, LLC, or corporation, additional planning may be required.

The important point is to identify the disagreement before the sale dictates the structure.

A structured planning discussion with the owners' financial, tax, legal, and 1031 professionals can evaluate how the property is currently owned, what each owner wants to accomplish, and which options may be available before a transaction is underway.

General Disclosure