To 1031 or Not to 1031 - Offset Capital Gains

6 Replies

So.. odd situation that I'm having trouble getting a solid answer to. Partner and I bought a MF property via LLC which now under contract. Partner does not want to go the 1031 route and is ok with the capital gains hit (approx 23k) and believes he can offset the gains with losses on other properties he owns. I want to go the 1031 route as I don't want to pay the 23k. I've been working with a firm on the 1031 side and they suggest dissolving LLC and moving the deed into our individual names prior to close. Then my proceeds go to the 1031 firm and I'm supposedly good to go. My CPA isn't so sure and hasn't come across this scenario prior and I'm having trouble getting an answer. Anyone come across this before? Alternatively can I not go the 1031 route and buy a distressed property and have my losses there offset the 23k? Much appreciated.

Originally posted by @Daniel Trzaskos :

So.. odd situation that I'm having trouble getting a solid answer to. Partner and I bought a MF property via LLC which now under contract. Partner does not want to go the 1031 route and is ok with the capital gains hit (approx 23k) and believes he can offset the gains with losses on other properties he owns. I want to go the 1031 route as I don't want to pay the 23k. I've been working with a firm on the 1031 side and they suggest dissolving LLC and moving the deed into our individual names prior to close. Then my proceeds go to the 1031 firm and I'm supposedly good to go. My CPA isn't so sure and hasn't come across this scenario prior and I'm having trouble getting an answer. Anyone come across this before? Alternatively can I not go the 1031 route and buy a distressed property and have my losses there offset the 23k? Much appreciated.

Yes, partnership cannot do 1031 exchange just for your portion of ownership. Partnership is not buying the property itself. In this care, your partnership is not the taxpayers that is doing the 1031 exchange, you are. 

You need to drop/dissolve the partnership, then do the 1031 only to the portion of your ownership. You can hold the title as TIC and start the process. @Dave Foster can help. 

Thanks for the reply.. Super Appreciated. So that's pretty much what I thought and how I intend to proceed. However, because I'm curious.. is it possible to minimize the capital gains hit with offsetting losses on another property I already own or that I will purchase with the proceeds from this sale? 

@Daniel Trzaskos , it's one of two options for you. The preferred option in the past would be to have the LLC do a partial exchange and purchase one property and keep the rest in cash. Once the 1031 was complete the LLC is dissolved and you would receive the property and the partner would receive the cash left after taxes are paid in the last LLC filing.

The option you've been presented with was not always looked at kindly by the IRS. However in recent times there's been a couple of rulings that indicate they're getting comfortable with this method. Commonly called a drop and swap. You dissolve the LLC and distribute the property to the former members. The fear was always that the IRS could claim the tenants had not acquired the property with the intent to hold and had actually acquired the property (from the LLC) primarily to sell. We're seeing them more frequently now. And accounts encouraging them are talking about primary intent being the dissolution and divorce of partners causing the title change.

Either way works.  But your accountant knows your situation the best.  So I'd lean on them which way they're more comfortable with.

@Daniel Trzaskos I've seen this scenario hundreds (thousands?) of times.  The advice given by your 1031 firm is fairly standard practice -- the "drop and swap" as Dave mentioned. 

There are some state governments that look more or less fondly on this strategy. The West Coast is particularly unkind, though there have been some major court victories there recently.  

The IRS also raises its hackles about this every other year or so, but they still allow the vast majority. They're very aware that this takes place and has done so for decades. 

The reason a "drop and swap" works is because partnerships can dissolve, distribute out their assets pro rata, and then carry on ownership of the properties as co-tenants. This distribution is tax-free under IRC section 731. 

However, a lot of real estate loans prohibit the partnership from distributing assets this way. And the closer to closing you engage in the dissolution, the more suspicious it looks to tax authorities. 

Your CPA is probably correct to be cautious, but my experience says that most CPAs (even very talented ones) can't be experts in the nitty gritty of every code section.  

Sean.. thanks for the info. You mention that the closer you get to closing the more suspicious the dissolution appears. That begs the question.. what would be a good time to execute the dissolution relative to close? A month prior? Six months prior? A ton of good info in this thread. Much appreciated.