2024 IRS RULING ANALYZES A TRUST BENEFICIARY TRANSACTING A 1031 EXCHANGE “DROP & SWAP”

By: James T. Walther, Esq., LL.M., General Counsel

In Spring 2024, the IRS published Private Letter Ruling 202416012 (“PLR”) analyzing a 1031 exchange scenario in which the beneficiary of an irrevocable testamentary trust transacted an exchange that is comparable to a “drop and swap” by a tax partnership. The “drop” into a tenant in common (TIC) arrangement between the beneficiaries was due to a mandatory winding up of the trust pursuant to its governing agreement. The trust document’s contingent termination provision effectively mandated an “involuntary drop” of fractional interests in title from the trust to the individual beneficiaries. The PLR addresses Section 1031’s qualified use requirement – that property be “held for investment or business purposes” considering a change of tax ownership in proximity to a 1031 exchange.

Legal Question: The Trust asked the Service to opine regarding the 1031 exchange “held for investment intent” requirement with respect to the beneficiaries exchanging tenancy-in-common interests in the Property as individuals.

General Background on Trusts: For purposes of determining the taxpayer transacting in a 1031 exchange, Trusts can be either disregarded or regarded for tax purposes generally depending on whether they are revocable or irrevocable at the time the real property is sold. For property held by a revocable grantor trust, the Grantor or Settlor is generally the exchanging taxpayer, with some exceptions. For most irrevocable trusts, like the one in PLR, the trust has its own tax identity as a separate taxable entity from the grantor and from the beneficiaries. Meaning, it files its own tax return reporting its own income as a taxpayer.

Ruling: The IRS respected the drop, the sale, and exchange of the newly distributed tenant in common interest as satisfying the held for investment requirement, even though it was sold by a beneficiary and not the trust.

Key facts and law presented in the ruling:

• The Trust that was originally the 100% owner of the real estate, but it had to dissolve and distribute property due to the death of one of the beneficiaries. It appears that the real estate was already in the sale process or under contract, when the contingent termination event, the death of the last child who had survived the decedent occurred.
• The Trust was an irrevocable testamentary trust that had a contingent terminating event in the Grantor’s Will that created it.
• It provided that upon the death of the last surviving child of the Decedent’s daughters, the Trust would liquidate and distribute its corpus of assets to the beneficiaries in due course.
• Per the Will, the Trust beneficiaries could not alienate their interests in the Trust, so it had to be dissolved upon distribution.
• The Trust held the property for investment purposes. 

Holdings:

• The IRS did not find issue with the fact that the newly issued tenant in common interest was not directly owned by the exchanger for a certain time period prior to the sale and exchange. It tacked the investment purpose from the trust to the exchanging beneficiary.
• The Trust Termination was inevitable and independent of the subsequent 1031 exchange by the beneficiary, and they were not an integrated plan. It was also likely to be approved in probate court.
• “The facts herein are distinguishable from those in Rev. Rul. 75-292 and Rev. Rul. 77-337, which involve voluntary transfers of properties pursuant to prearranged plans.”
• The IRS ruling indicates that they see no investment intent or holding period issues here because the “drop” would have occurred independently of the subsequent exchange. They do not view this as an integrated plan scenario where a partnership operated the property for years and then dropped TICs with the primary purpose of structuring exchanges for different taxpayers.

The IRS and the “1031 Holding Period” Argument: A Shift in Focus?

A chief concern regarding the distribution of appreciated property by an entity to a partner or trust beneficiary is whether the subsequent sale of the property would fail to meet Section 1031’s qualified use requirement for the individual receiving the property. Many investors tend to focus on a holding period or time they must hold a property in order to create a presumption of an investment purpose.

The short answer is that a taxing authority arguing that a drop-and-swap exchange should be disallowed, based solely on the exchanger holding real estate for a short period, is likely a thing of the past. Most cases where the IRS tried to litigate the “held for investment” issue have been favorable to taxpayers. See Field Service Advice 199951004 (FSA), which provides internal guidance to agents that challenges to drop-and-swap structures based on investment intent have not held up well in litigation.

 “We do not recommend pursuit of the argument that Taxpayer did not hold the property for investment within the meaning of section 1031(a). As you have noted, this position has been rejected on several occasions. See Magneson v. Commissioner, 753 F.2d 1490 (9th Cir. 1985); Bolker, 81 T.C. at 804-805. Although we disagree with the conclusion that a taxpayer that receives property subject to a prearranged agreement to immediately transfer the property holds the property for investment, we are no longer pursuing this position in litigation in view of the negative precedent.”

The IRS is currently unlikely to challenge a drop-and-swap exchange solely based on investment intent or holding period. Instead, the IRS is more likely to use a “substance over form” argument when attacking a drop-and-swap or similar strategy. In the subject 2024 PLR, the taxpayer had no other option but to complete the exchange as a tenant-in-common with the other beneficiaries because their real estate interest was subject to the rules set forth in the governing document long before the exchange was contemplated.

In limited situations, the IRS has become more relaxed with respect to holding periods as a component of investment intent. However, it still focuses heavily on the time component of ownership in other contexts, such as cases involving potential dealer property or inventory or whether a taxpayer has short-term or long-term capital gain. Nonetheless, we believe that in several circumstances other than entity or trust dissolutions, the length of ownership is still a relevant component in analyzing whether a taxpayer met §1031 investment criteria, even though it is not a decisive factor. While not decisive, a short-term hold of replacement property could signal taxpayer’s intent to re-sell, more so when coupled with other factors.

This ruling reminds us that special considerations arise when a Section 1031 exchange involves real estate that may have recently been held by a different taxpayer or in a different form prior to the exchange commencing. Like the taxpayer who requested a ruling from the IRS, investors should take care to discuss these issues with a qualified tax advisor. This ruling is informative because it provides insight into current stance of the IRS on this issue and related legal doctrines, but has limited value to taxpayers other than the one who requested it.

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