Swap and Drop Exchange Upheld by Oregon

As we've previously indicated, there are situations where a partnership may split up or liquidate but one or more partners may want to defer capital gains through the benefits of a 1031 exchange. Perhaps the partners have different goals or they simply no longer want to stay in business together. Partners often want to go in different directions with their share of the proceeds. Some may want to reinvest in real estate and can defer their taxable gain through use of a 1031 Drop and Swap.

The opposite can also happen where an investor exchanges a property and wants to enter into partnership with other investors. This is known as a "Swap and Drop". This investment would take the form of a tenancy-in-common interest in the property. It has been previously thought by many tax professionals that this undivided fractional real estate interest should be maintained for a sufficient period of time in order to satisfy the 1031 "held for investment purposes" requirement.

However, a recent court case in Oregon puts some doubt into whether this is really necessary. In the case of the Oregon Department of Revenue v. Marks taxpayers had acquired a tenancy-in-common interest as replacement property for their exchange. They then immediately contributed the replacement property to a partnership (a "swap and drop"). The Oregon Department of Revenue (affectionately referred to hereafter as ODOR) challenged the exchange based on the partnership "drop". The original court ruled that the taxpayers had indeed met the guidelines of a 1031 exchange and it was permissible to exchange and then immediately contribute the property to a partnership. ODOR appealed that decision but the Tax Court upheld the original ruling.

Within the appeal ruling the Tax Court referenced the 9th Circuit court case of Magneson v. Commissioner. In that case, the 9th Circuit held that the transfer did not impair investment intent and that the transfer to the partnership changed the form of ownwership but not the substance of real property ownership. The Tax Court determined that the taxpayers' continuity of interest and lack of cashing out override the ODOR's concerns about the short holding period of the replacement property.

This is significant in that Magneson preceded adoption of a subsection of IRC 1031 ((a)(2)(D))that excludes partnership interests from property that can be exchanged. It appears from the reference that the court continues to affirm the view that the partnership is an aggregate of its partners (in contrast with a corporate entity status being seaparate from its shareholders.

It should also be highlighted that the Oregon court case only applies to Oregon STATE tax and not to Federal tax. The assertive Franchise Tax Board in the state of California is reportedly pursuing a case contesting the "Swap and Drop" tax strategy. It appears that case involves similar arguments that the immediate transfer demostrates the taxpayer lacked investment intent at the time of acquisition.

Neither the statute, the Revenue Code, the IRS, nor the courts have provided complete certainty in this area. The 2008 Partnership Tax Form 1065 was revised to include questions regarding "Drop and Swaps" and "Swap and Drops". This change was made to "enable the IRS to focus compliance resources on returns and issues that warrant examination. What, if any, resources is unclear. But it does appears that the IRS has some interest in continuing to fight court cases involving "Drop and Swaps" and "Swap and Drops". If you are contemplating such an exchange, you should consult with your tax professional(s) and speak to your 1031 exchange professional early in the sale process to attempt to understand and mitigate your financial risk. Of course, if you have any questions about 1031 exchanges, you can give us a call free of charge at 888-367-1031.