When partners in a partnership wish to sell appreciated assets and go their separate ways, a drop-and-swap has long been the go-to tax planning strategy employed.1 In a drop-and-swap, the partnership distributes tenants-in-common (TIC) interests in partnership assets to partners in redemption of their partnership interests, permitting the TIC owners to individually determine whether to cash out or reinvest in new assets.2 A chief limitation of the drop-and-swap is that the strategy is only available to taxpayers who plan prospectively. Drop-and-swaps are viable only until that point in time when a partnership has established an intent to sell property.3 After a partnership has established intent to sell, a drop-and-swap runs a heightened risk of Internal Revenue Service (IRS) challenge.4 A partnership to Delaware Statutory Trust (DST) conversion offers a possible solution for taxpayers when a drop-and-swap is no longer viable.
DSTs can be structured as multi-beneficiary grantor trusts for federal income tax purposes.5 A grantor-beneficiary of a DST classified as an investment trust under Treas. Reg. § 301.7701-4(c) is treated as the owner of an undivided interest in each DST asset equal to such grantor’s beneficial interest in the DST. A 10% grantor-beneficiary of a DST owning investment real estate is treated, for federal income tax purposes, as owning an undivided 10% interest in the underlying investment real estate. In 2004, the IRS issued Rev. Proc. 2004-86, determining the circumstances upon which an interest in a DST could be acquired as replacement property to complete a § 1031 exchange commenced by a taxpayer selling real estate. The IRS’ conclusion in Rev. Proc. 2004-86 spurred the growth of syndicated DST investment products marketed to the § 1031 industry, and the corresponding decline of syndicated TIC investments. However, the value of DSTs in § 1031 tax planning should not be limited to syndicated real estate investment products.
DSTs may offer a practical solution to clients who do not seek advice early and can replicate the tax-effect of a drop-and-swap. If clients call with a purchase and sale agreement in hand, a drop-and-swap is no longer a viable option because the partnership has expressly evidenced its intent to sell property.6 Late implementation of a drop-and-swap can be challenged based on, among other things, the assignment of income and step transaction doctrines.7 The IRS could also argue that the TICs have not complied with the held for investment requirement of § 1031(a)(1). The partnership may nonetheless be able to achieve the partner-level tax results of a drop-and-swap by completing a DST conversion, even after the purchase and sale agreement is signed.
In this strategy, the partnership converts to a DST under state law. The conversion is completed prior to closing on the sale of the relinquished property.8 The conversion causes the partnership to liquidate for federal tax purposes and each partner receives an undivided interest in each partnership asset and liability equal to such partner’s interest in the partnership, but the DST is regarded as a continuation of the partnership for state law purposes.9 When structured properly, the DST will be classified as an investment trust under Treas. Reg. § 301.7701-4(c) and each partner in the partnership will be a grantor-beneficiary of the DST. The DST may then sell property and each beneficiary may independently determine how to reinvest their share of sales proceeds. As the conversion to a DST is accomplished without a transfer of the partnership’s assets by virtue of the operation of Del. C. § 3820, the DST remains the same taxpayer that signed the purchase and sale agreement and, as with a corporation undergoing a mid-exchange merger, the transaction should not violate the § 1031 same taxpayer rule.
The IRS has previously issued favorable rulings to corporations engaging in mergers during the exchange period wherein the predecessor corporation sells relinquished property to commence a § 1031 exchange and the surviving corporation acquires the replacement property.10 When examining mergers occurring during the exchange period, the IRS has placed significant weight on state law aspects of the transaction to determine that the same taxpayer rule, assignment of income or step transaction doctrines have not been violated. The surviving corporation in a merger may complete a § 1031 exchange commenced by a predecessor corporation because the predecessor and survivor become the same legal entity by operation of law.
DST conversions represent a possible solution for last minute § 1031 planning when partners wish to go their separate ways, but until IRS issues a ruling expressly authorizing this strategy, drop-and-swaps will remain the favored strategy for advance planning. Even without IRS guidance, when reactive planning is required and the luxury of flexibility has vanished, DST conversions may provide a tool to synthetically replicate the partner-level tax effect of a drop-and-swap.
Matthew R. Joyce, J.D., LL.M. is a tax attorney with extensive experience in tax planning for real estate transactions including § 1031 exchanges. Matt is an associate in the tax planning department of McLaughlinQuinn LLC. Matt received his B.S. in Business Administration and B.A. in Political Science from the University of New Hampshire, his J.D. from Roger Williams University School of Law and his LL.M. in Taxation from Boston University School of Law. Matt is a member of the American Bar Association Tax Section and the New Hampshire Bar Association Tax Section.
1 The pre-sale distribution of a TIC interest in partnership assets and liabilities in redemption of a partner’s interest in a partnership prior to a § 1031 exchange is commonly known as a “drop-and-swap”. Other viable options for prospective tax planning generally include the swap-and-drop and the partnership division. Each option is unique in its requirements and application. Choosing the best option requires careful analysis of the facts and circumstances of each transaction together with the intended results sought by the taxpayer.
2 Transactions resulting in TIC ownership arrangements must be carefully structured to comply with IRS guidance including, as one alternative, the safe harbor established by Rev. Proc. 2002-22. TIC ownership arrangements not structured or operated in accordance with IRS guidance are at risk of being classified as a partnership for federal income tax purposes.
3 Viewed from a substance over form perspective, IRS has historically sought to determine when the seller evidenced an intent to sell relinquished property and engage in a § 1031 exchange. A change in the identity of the seller after intent is established will be considered a change in taxpayer. A binding contractual commitment to sell property, such as entering into a purchase and sale agreement, is arguably the most authoritative indicator of intent though other evidence of intent must certainly be considered. See Chase v. C.I.R., 92 T.C. 874 (1989).
4 Implementing a drop-and-swap after a purchase and sale agreement has been signed by the partnership can be challenged under the assignment of income and the step transaction doctrines. Alternatively, the IRS may also challenge the investment intent of the partners turned TICs under § 1031(a)(1), citing the short holding period of the newly created TIC interests.
5 IRS has previously ruled that a DST can be structured so as to be classified as an investment trust under Treas. Reg. § 301.7701-4(c)(1). See Rev. Proc. 2004-86.
6 See Chase v. C.I.R., 92 T.C. 874 (1989).
7 Drop-and-swap transactions run the risk of being challenged by the IRS as lacking the investment intent required by § 1031. Where the holding period of TIC property is relatively short, the transaction runs a heightened risk of an IRS challenge. See Rev. Rul. 77-297 and Rev. Rul. 75-291. No definitive guidance exists establishing a minimum holding period and cases examining this issue have held that the intent of the taxpayer is dispositive. See Bolker v. C.I.R., 760 F.2d 1039 (9th Cir. 1985). In Bolker, the taxpayer was the shareholder of a corporation which owned investment property. The taxpayer caused the corporation to liquidate in a tax free transaction, receiving title to the corporation’s investment property. On the day the taxpayer took title to the investment property, the taxpayer entered into an exchange agreement for the property. The IRS challenged the taxpayer’s investment intent due to his short holding period but the Court upheld the exchange, reasoning that the taxpayer’s intent to exchange property for like-kind property can satisfy the held for investment requirement of § 1031(a)(1).
8 The IRS has previously ruled that, for corporate taxpayers, the carryover of tax attributes in a merger transaction covered by § 381 applies to permit the successor corporation in a merger to acquire replacement property to complete a § 1031 exchange initiated by the predecessor corporation. See Ltr. Ruls. 9751012 and 200151017. The author of this article is not aware of any comparable rulings for partnerships that indicate that a successor partnership in a merger transaction may complete a § 1031 exchange initiated by a predecessor partnership. Indeed, as to partnerships, the IRS has previously indicated in Ltr. Rul. 200812012 that certain technical terminations under § 708(b)(1)(B) will violate the qualified use requirement of § 1031. The IRS’ position in Ltr. Rul. 200812012 tends to indicate that the IRS would likely determine that a technical termination creates a new taxpayer for purposes of the same taxpayer rule.
9 12 Del. C. § 3820. Under the Delaware conversion statute, the assets, liabilities and contracts of the partnership become the assets, liabilities and contracts of the DST. Delaware’s conversion statute expressly directs that the conversion shall not be construed as a transfer of assets or liabilities from the partnership to the DST, operating in a manner akin to a corporate merger statute.
10 See Ltr. Rul. 9751012 and Ltr. Rul. 200151017.