Now let’s address a situation where you own a property, in Houston, Texas, under an entity with three other partners, let’s say your name is J and your partners’ names are S, A, and K and the entity’s name is JKSA LLC. The property is about to be sold and you and K would like to do a 1031 exchange but S and A are not interested in doing so, they would like to receive their share of the proceeds at closing and go their separate ways, can you and K do a 1031 exchange? Let’s talk about it.
In order for you and K to proceed with a 1031 exchange, there will be a lot of advanced planning into structuring the deal so that you and K can proceed towards purchasing another property and S and A can go their separate ways. This process is called “drop and swap”, what happens here is that S and A will leave JKSA LLC and then only you and K will be left on the entity and then JKSA LLC will deed 25% of the ownership interest in the property to S and the other 25% to A and then after this process is done, the property will be owned 50% by JKSA LLC, 25% by A and the other 25% by S, all as tenants in commons.
If S and A, do not wish to own the property under their individual name, that should be fine, they can form their own entity and have each other on there and then JKSA LLC will deed a 50% ownership interest in the property to whatever the name of S and A’s new entity will be.
In continuance, at closing, the title company should be able to divide and wire the sales proceeds accordingly and that’s when S and A can take their share of the proceeds and go do whatever they so desire and JKSA LLC (under which you and K are) will be able to do a 1031 exchange and purchase the next replacement property under JKSA LLC.
A few things to keep in mind with this process is that it is best to complete the above-mentioned deed transfer from JKSA LLC to S and A, at least 2 years prior to selling the property because the deed transfer is technically considered a sale and the ideal holding period of an investment property is preferably 2 years before you decide to do a 1031 exchange. This is why it is best to communicate with your partners as early as possible to figure out what all of your intentions will be with the property a few years down the line.
Another thing to keep in mind is your bank, if the property was purchased using a bank loan, please consult with your banker prior to engaging in this “drop and swap” strategy because chances are if you sell any shares in JKSA LLC to anyone and if you also deed any ownership interest in the property to anyone else, your bank may consider this is as a default on the loan and may call the loan amount immediately due. This is why it is important to notify your bank in advance and explain that your intentions with this strategy is for you and K to engage in a 1031 exchange upon sale of the property and for S and A to go their separate ways at closing.
Lastly, please also consult with your CPA and tax advisors before executing anything mentioned in this blog.