California limited liability company disputes | Courtroom war stories and lessons learned

“Drop and Swap” — Tax-Friendly Handling of a Dissolving LLC’s Real Property

A common LLC problem:

LLC members are ready to call it quits on the LLC and divide their interests in the LLC’s real property.

Some members may want to sell, receive cash, and recognize gains for tax purposes.

Other members may want to do Internal Revenue Code section 1031 exchanges to different properties and avoid the tax hit that would otherwise be triggered by a sale.

Normally, the LLC — as sole title holder to the property — would have to either: (1) sell its property, take the tax hit, and distribute net proceeds (after taxes) to members; or (2) do a 1031 exchange of its property to a different property to be owned by the LLC.  But neither of those options are satisfying to members who want to disband the LLC and go their own way, but want to avoid realizing gains on the property through a sale.

(The same problem arises in partnerships too.)

A solution:

The “drop and swap.”

How a “Drop and Swap” Works

In a “drop and swap,” the LLC’s property is transferred to members as separate tenancy in common (TIC) interests, which generally will not trigger taxes.  This part is the “drop.”

Each TIC interest holder can then decide what to do with their interest.  They can sell, receive the cash, and report the gain, or they can do their own 1031 exchange (the “swap”).

Gray Area

One area of uncertainty surrounding a “drop and swap” has been the “held for” requirement under the Internal Revenue Code.  The length of time the TIC interest must be held is not specified in the Code.

The California Franchise Tax Board (FTB) has aggressively challenged some of these transactions when there is insufficient time between the “drop” and the “swap.”

Office of Tax Appeals Provides Guidance

Earlier this year, the California Office of Tax Appeals (OTA) issued a ruling — In the Matter of the Appeal of Sharon Mitchell — denying the FTB’s request for a rehearing in a case providing guidance for drop and swap transactions.

In the Mitchell case, the taxpayer (Sharon Mitchell) followed a drop and swap procedure for property initially owned by a general partnership.  Her partnership interest was converted to a TIC interest, and then when the property was sold she exchanged her TIC interest for like-kind property under section 1031.

The FTB challenged the exchange and attempted to impose an immediate tax bill of over $60,000.  The FTB took issue with the fact that only the partnership negotiated and entered into the sale agreement with the buyer, and the partnership gave the TIC interest to Mitchell only days before the closing of the sale.  The FTB contended that the true seller of the property was the partnership, and therefore Mitchell’s 1031 exchange was invalid.

In a 2-1 decision, the OTA sided with Mitchell, concluding that she was the true owner and seller of her TIC interest, and was therefore entitled to the tax benefits of her 1031 exchange.

The FTB petitioned for a rehearing, arguing that the decision went against the FTB’s long-standing critical views toward “drop and swaps.”  But the OTA denied the petition, leaving the decision in favor of Mitchell intact.

Lesson

The OTA’s decision in Mitchell is non-precedential and not binding for federal income tax purposes.  But the IRS has not traditionally been as aggressive toward “drop and swaps” as California’s FTB.  And the Mitchell decision seems to signal that the FTB’s aggressive stance will lighten.

While the Mitchell decision is generally favorable toward “drop and swaps,” it is probably risky to assume that similar transactions (with the “drop” occurring very close in time to the sale) will always be upheld.  Instead, the safest approach is to follow these industry tips:

  • Convert the real property interests from the entity into TIC interests as early as possible, before taking any steps to market or sell the property.
  • The TIC owners will probably want to form a TIC Agreement to address expenses, profits, etc.  Each TIC owner might also want to form their own LLC to hold their interest in order to limit liability.
  • Let some time elapse while holding the property in TIC interests.  This indicates an intent to hold as investment property instead of an intent to avoid taxes.  There is no bright line holding period, but many experts advise holding for at least one year or one tax reporting period.

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