If you invest in real estate through an LLC or limited partnership, you may get a packet one day asking you to sign a co-ownership agreement and a deed. That usually means the sponsor is doing a "drop and swap." Several of our clients have been through one recently. Here is what to know as an investor and what to expect next.

What a drop and swap is

A 1031 exchange lets you put off paying tax when you sell one investment property and buy another. It only works for real estate itself. Your units in an LLC or partnership do not count. Before 2018, the law said so directly. Today it limits exchanges to real estate.

A drop and swap is the workaround. The LLC "drops" the building out to its investors. Each investor ends up owning a slice of the building directly, as a tenant in common (a co-owner on the deed). Then each investor decides on their own. You can roll your slice into a new property, or sell it and take cash.

Sponsors do this when investors want different things. Some want to roll into a new deal. Others want out.

What you will be asked to sign, and how fast

Expect a co-ownership agreement, a deed that puts your slice in your name, and often a new management agreement. These can arrive close to the sale date, with a short deadline.

Take the time to read them. Signing turns you from a passive investor into a direct owner of real estate. If the timeline feels rushed, ask the sponsor in writing why, and ask for the closing date.

What changes when you own your slice directly

  • Ownership. You own a percentage of the building, on title, instead of units in a company.
  • Liability. The LLC no longer stands between you and the property. Ask what insurance covers you and whether you are signing onto any loan.
  • Financing. If there is a mortgage, the lender usually has to approve the change. Ask whether you are becoming a borrower or guarantor.
  • Management. Under IRS guidelines for these co-ownership deals, big decisions like selling, leasing, refinancing, or hiring a manager need every co-owner to agree. Read who decides what in your agreement.
  • Your vote and exit. Check whether you can sell your slice, whether the others get first dibs, and whether you can force a split or sale.

Why the IRS may question it

To qualify, you have to actually hold the property as an investment. If the LLC hands out the deeds and the sale closes a few days later, the IRS can argue you never really owned it. It can say the LLC was the real seller.

Courts have gone both ways. Some investors won when they really did own and act like owners. One investor lost because the facts showed the partnership still ran the show. He did not record his deed until he knew the sale would close, and he took no share of the rent or expenses in between. The lesson is simple. What actually happened matters more than the paperwork.

Your final K-1 and capital account

The LLC should send a final K-1 for the year it handed out the property. Look for the "final K-1" box and your ending capital account.

Getting property out of a partnership is generally not taxable by itself. Your tax cost in the property usually carries over from your cost in the LLC. Your holding period usually carries over too. If your K-1 shows a positive ending balance after everything was handed out, or a gain you did not expect, ask the sponsor and your CPA how it was figured. Cash you receive along the way can be taxable if it is more than your tax cost.

Exchange or cash out

If you exchange, you have 45 days to name your replacement property. You have 180 days to close, or until your tax return is due with extensions, whichever comes first. A qualified intermediary (a neutral company that holds the money) should hold the sale proceeds so you never touch the cash. Any cash you keep, or any drop in your loan amount, is taxable. You report the exchange on IRS Form 8824.

If you cash out, you are selling your slice. Your gain is based on your carried-over cost. Gain from past depreciation can be taxed at up to 25 percent federally.

California follow-ups

If the property is in California, escrow generally holds back 3 1/3 percent of your share of the sales price for the state, unless an exemption applies. This shows up on Form 593.

If you trade California property for property in another state, you must file Form FTB 3840 with California every year until you sell the new property. California keeps track of the gain you put off.

Questions to ask the sponsor

  • Why a drop and swap, and when will the sale close?
  • Who is on title, and when will the deed be recorded?
  • Am I taking on any loan or guarantee?
  • Who is the qualified intermediary?
  • How was my ending capital account figured, and when will the final K-1 come?

Documents to keep

Keep the co-ownership agreement, the recorded deed, the distribution letter, the final K-1, the closing statement, the intermediary agreement and statements, your 45-day identification letter, and Form 593. Keep them as long as you own any replacement property, plus the years after you sell.

When to call your CPA

If you have not signed yet, call before you do. If you already signed, that is common, and it is not too late. Call now so we can review the documents, the timeline, and your final K-1 before your return is filed. Call as well if the closing is weeks after the handout and you have not seen a deed, if your K-1 looks off, or if you are moving California property out of state.

Every deal is different, and the facts drive the result. If your sponsor has sent you co-ownership papers, or you are holding a final K-1 you are not sure about, reach out. We are happy to walk through it with you.

This article is general information and not tax advice for your situation.

Sources: IRC §§1031, 731, 732, 735, 1(h), and former §1031(a)(2)(D). Treas. Reg. §§1.1031(k)-1, 301.7701-1. Rev. Proc. 2002-22. Rev. Rul. 75-292. Magneson v. Commissioner (9th Cir. 1985). Bolker v. Commissioner (9th Cir. 1985). Mason v. Commissioner, T.C. Memo. 1988-273. Chase v. Commissioner, 92 T.C. 874 (1989). IRS Form 8824. FTB Form 593 and FTB 3840 instructions. Full links in SOURCES.md.