The 1031 Exchange “Drop and Swap” is a strategic approach where a property held by a partnership is first “dropped” to individual partners, then promptly used in a like-kind exchange transaction (the “swap”). This two-step maneuver can allow individuals to conduct separate exchanges and potentially defer capital gains taxes under Section 1031. While this structure is not explicitly prohibited under federal or Maryland law, it must be carefully executed to avoid IRS disqualification.
The core issue stems from the IRS ban on exchanging partnership interests under Section 1031. Because an interest in a partnership is not “real property,” a direct exchange of partnership interests fails to qualify. Instead, the entity (often a limited liability company or partnership) may transfer the property to its partners as tenants-in-common. After that distribution, each partner can pursue a 1031 exchange in his or her own name.
However, “drop and swap” transactions often face close IRS scrutiny, especially if the “drop” occurs immediately before the exchange. The IRS may argue that the quickly executed sequence is a “step transaction,” where multiple steps are collapsed into one, nullifying the taxpayer’s intended deferral. To mitigate this risk, Maryland taxpayers should consult with tax counsel and consider holding the property as tenants-in-common for a period of time before exchanging.
Maryland generally respects federal definitions and guidelines for 1031 exchanges. Although Maryland does not impose unique rules restricting “drop and swap,” state and county transfer taxes could apply to any change in ownership. When a property transfer occurs in Maryland, recordation and transfer taxes may be triggered if the state deems the transaction to be a taxable event. Consulting a qualified intermediary and a real estate attorney who is well-versed in Maryland law can help identify and minimize tax liabilities.
It is also vital that all formalities are followed in re-titling the property as tenants-in-common, documenting capital account adjustments, and maintaining correct ownership records. These records, along with evidence of intent to hold the newly titled property for investment or business use, help support the legitimacy of each partner’s exchange.
Because “drop and swap” structures push the boundaries of straightforward 1031 transactions, Maryland investors should ensure they fully comply with formalities. Preserving a clear paper trail, showing intent to hold, and avoiding rushed steps are critical for promoting a defensible transaction.
FREQUENTLY ASKED QUESTIONS
1. Can an LLC or partnership in Maryland do a 1031 exchange without dissolving first?
Yes. An entity can execute a 1031 exchange directly as long as the exchanging party remains consistent. However, if individual partners want to perform separate exchanges, a “drop and swap” may be required.
2. Does Maryland have special 1031 exchange rules that differ from federal law?
Maryland generally follows federal guidelines for 1031 exchanges and does not impose separate requirements. However, transfer and recordation taxes may apply, so local advice is recommended.
