WIN173. Drop & Swap Explained: How Syndicators Handle 1031 Exchange with Dugan Kelley

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Chris: Oh, with chatting with Michael, he said, you know, that you are awesome, but very difficult to get ahold of. He literally said, you have to chase him.

Dugan K: Well, you got the main gatekeeper. So Tessa is the, she's the holder of all things my calendar. She literally has me going running 20 fourseven. So you blame her for not having enough time to pick up my own phone.

Chris: Well, she must be doing a good job.

Dugan K: Yeah, she is definitely doing a good job. I couldn't live my life without her.

Tessa: Thanks, Chris. I appreciate that as he's trying to throw me under a bus and then run back over. I appreciate you sticking up for me. Well,

Chris: cool. Why don't we jump into it? We're we have a syndication that we put together six years ago, and we wanna sell it while we're in contract to sell And we're almost through the inspection period. We're probably about thirty days away from closing. And we haven't reached out to our partners yet about because we've had a few sale fails in the past, so we're kind of Right.

Hoping, waiting.

AJ: Kinda waiting until the inspection period is up before we really, like, sound the alarm bells.

Dugan K: Till the earnest money till the earnest money is hard. Right? Everybody's committed fully.

AJ: Yep. Yep.

Chris: Got it. So that's where we're at. But we know I know of at least two investors who want their cash out. AJ and I are working diligently on finding the next leg up. So, I mean, essentially, we're we're trying to limit the liability of an exchange being invalidated.

Dugan K: Oh, okay. Alright.

Chris: And then just kind of and then we have another

AJ: I mean, like, I think Chris, I think we like, let's get to the question. I mean, we we we understand that there's, like, the swap and drop and drop and swap kind of process. Right. And, you know, for for our listeners and for everyone, like, I think we could all benefit if you could give us kind of an explanation of like how that works and, you know, what what it is.

Dugan K: Yeah, of course. So the IRS has this special code that some people may still not have even heard of. It's my favorite part of the tax code and it's section ten thirty one. It allows investors such as your retail investors to essentially sell what they what the IRS calls a relinquished property and replace it with what they call a replacement property and do that in a tax free manner. So they're able to actually shelter the gains that they've received.

So what happens when you have syndicators, operators, sponsors, I use those those terms interchangeably with one another, who own a property. They have investors. Some of those investors theoretically don't wanna take the cash and pay taxes, and other investors want the cash and to pay taxes, but they all are in the same entity with one another. And that same entity is currently what we would call a special purpose entity that the lender required us to form at acquisition of the property that we're selling. We do what we call, we do what AJ said and it's called a drop and swap.

So it's essentially taking, and this is done usually through a ballot process. So we're contacting all of the investors, telling them exactly what we're doing, and asking them whether they wanna go through a forward exchange or whether they wanna take their cash and pay their taxes. I should say this is not a magic wand. Right? So ten thirty one is a tax deferral process.

It's not a tax waiver, process. So the taxes on that you would pay on the gains from the sale of the property, you're simply deferring those until until they become until they ripe till they ripen. Now, ultimately, I have clients who for generations have essentially done ten thirty ones, and that is theoretically a you're able to waive all those those taxable gains through a step up in basis. But ultimately, what we wanna do is we wanna give investors a choice. We wanna be able to give them through usually, it's through a ballot process.

You're basically asking them affirmatively, do you want to get out of this deal or do you want to go with us into the next deal? And for people that say, yes, I want to go through, the next deal, they're going to be staying in the same entity because that entity is what we call season. Meaning, it's owned the property for a number of years, and it's not the newly formed entity. Investors who want their cash and are prepared to pay their taxes are dropped into a new entity. And essentially what we do is we create what's called a tenant in common structure.

That simply means from the IRS's perspective that there are now two owners of what the IRS calls undivided interest in real real property. So take your apartment building, for example. If you were to give your investors choice as to whether to take their money, through the form of distributions and pay their taxes on their personal tax returns or to stay in the same entity and go forward through a forward exchange, which you, the sponsors would be able to choose the next investment opportunity just like just like you chose the investment opportunity that the investors invested in. Do the first time, we create, another entity. That entity has a similar operating agreement, and we simply drop we drop investors from the existing entity into that entity, thereby creating essentially two owners of the same piece of real property, and that's what we call a tenant in common structure.

So that's kind of like a 30,000 foot foot, viewpoint of of the structure and kind of the mechanics behind it. But ultimately, it's it's trying to give investors more choice. And from a sponsor's perspective, it's it's obviously you're helping your your investors find a replacement investment. And most retail investors, as you guys know, right, they're they don't wanna be asset managers. They don't wanna be sponsors, operators, syndicators.

That's why they invested with you. They wanna they want you to find the next investment opportunity for them, and this provides them, an excellent resource to do so.

AJ: Nice. And the 10 in common, I often hear just ticks. Yes. As like a a nomenclature kind of, like, abbreviated. Cool.

So when we go into the new property, presumably, it's gonna be another syndication. It's gonna be a leg up. So, you know, for rough numbers, I mean, like, say we have 500 k from this one sale and we've gotta raise 2,000,000 for the next sale. Like, my my understanding is that we have to come in with a tick as well into the new property. So, like, how how how does, like, the original swap get put into the syndication, like, after you get into the next leg up?

Dugan K: Right. So let's so so let's just let's let's think about the structure this way. So you're in the process of selling this apartment building. You have some investors who have decided, yes, I wanna go into this next investment opportunity. AJ and Chris have.

So we go through the closing process. That money that, theoretically is going to be invested as a tick goes to a what we call a qualified intermediary. That's simply like an escrow officer that maintains the safe harbor provisions of the of the ten thirty one process.

AJ: Sure. And that's like that's like a exchange exchange company. Right?

Dugan K: They're they they they That's like an exchange company.

AJ: Yeah. Part of the ten thirty one is you can't touch the money. Right? Like, I touch the money, that's like, we're done. You're dirty.

Taxes.

Dugan K: Uncle Sam uncle Sam is waiting with his with his mitts fully out, ready to stuff them in both of your pockets. You touch the money, he gets the ability to to pull pull taxes from you. If he doesn't if you don't touch the money through the qualified intermediary, he can't do that. But you're touching on one of the one of the other important points, that is the IRS requires the same taxpayer that sold the replacement property to be the same taxpayer on the replacement property. So when you think about the next investment opportunity, that will also be a tick.

It will also be a tenant in common, structure. And if you're syndicating the balance of the equity, and when we say equity, I like to use the analogy that most people bought their, if they own their own residential home, they showed up at the title company. The title company said, what's the down payment? When we talk about syndicating equity, what we're really talking about is syndicating the down payment that's required in order to get the loan to buy the asset. And because these are these are large apartment buildings or large transactions, not all of us are carrying around a suitcase full of cash.

So we need to we need to have multiple people participate and contribute their cash. So in your case, you've got a good head start. You've got a good head start on that down payment because you've got money that's sitting at a qualified intermediary that's going to be one of the owners of the next, piece of property, but you don't probably have enough with just the $10.31 money to fully fill out the down payment. So we have to syndicate separately that down payment and and that down payment will be syndicated through another entity and that entity will also take ownership in the next piece of real property and and you'll have a tick. So whereas the drop and swap is creating a tick at the end of the transaction, a tick on reinvestment will be created at the opening at the acquisition of the new piece of property.

AJ: Right. And then my understanding too, and you know, I'm probably educated just enough to be dangerous. Okay. But so, you know, we swap into this new property. So now we've got two ticks.

You know, the syndication raised, you know, 75% of the money and the swap tick had 25% of the money. Like, the the the $10.31 tick has to season before you can then really, like, drop it into the syndication. I mean, I guess I'm just kind of unclear how maybe that works. I mean Yeah. So maybe I have, like, the, you know, overall 40,000 foot view of it.

But

Dugan K: Right. So you're you're actually not gonna be the the the tick that's coming into your next investment's not gonna be an investor in your next syndication. They'll actually be a co owner of the same piece of real property. So when you're going to look for leverage with whether it's an agency, Freddie or Fannie, or whether it's a bridge lender or if it's even like a hard money lender or a local community bank, you're gonna wanna make sure that, you tell them that there's gonna be at least two borrowers. There's gonna be at least two co owners of that same piece of real property.

So you don't need that $10.31 money that's sitting at the qualified intermediary to season for to invest into your next syndication. They just continue into that investment and then provided that your lender allows a tenant in common structure to exist, you'll have two borrowers, two co owners, but the same sponsor group will control both borrowers. So that's the key, right? So the same sponsor group will control both.

AJ: Yeah, the sponsor, yeah. We we will be the sponsor in this this kind of like scenario and we will be the, yeah, controller of both those entities. I I guess my my

Dugan K: I was just gonna say, you're you're the you hit on a an important point from the standpoint of imagine if you wanted to do a HUD deal. So HUD is an agency lender. It's it does not allow ticks. So when we when when when we do a HUD deal, we really have to utilize what's called a roll up structure. And most CPAs will tell you that an entity to AJ's point has to be seasoned before it gets into another entity where essentially it now receives k ones and partnership returns.

There's a famous, tax court case out there that where the IRA or where the tax tax court allowed that to take place and basically said it's okay to utilize our roll up, in this context. But most CPAs will say you need to have had the, the the investment for at least a year, which is like the short term capital gains period. So that's the only context of when we're really talking about a seasoning that needs to take place and it's basically what the whole the whole period is.

AJ: So, like, once you you know, in order to quote, unquote perfect the 10/31, my my understanding was that it needed to season with the property as that tick structure as and then and then it was able to be dropped into the syndication because as the GP, my I guess, you know, the the the structure and the fees on the new property may be different than the previous property or like that like, how I'm like, I guess I'm just I'm I'm unclear as to, like, how that works and whether there is some sort of requirement or if it's like a gray area. And, you know, what I've heard is more of a, best in practice as opposed to, law or, like, just a requirement.

Dugan K: If you if you wanted your ten thirty one company to be an investor directly into the syndication and you wanted it so instead of having a tick structure, you said, I I don't want a tick structure. I don't like ticks. I just want a single entity, a syndicated entity, and I want my my ten thirty one entity to essentially be treated as an investor, most CPAs would say, well, you would have to wait essentially year before you essentially drop them into another entity and that would be that seasoning period. So we try to take out that level of uncertainty or that level of grayness or the possibility of if we were in the unlikely position of picking up an audit or having to fight this in tax court to maintain that tick structure. And then for people like AJ or Chris or other sponsors that have a deal where the economics of the promote, meaning the carried interest or the fees that you're hoping to have may have changed from the original investment into the next investment.

And that's okay. And we're able to achieve those same economic realities that the sponsors want by having the sponsors as non member managers. So in other words, you maintain the same taxpayer side on the tick investment and you don't you're not requiring to have a seasoning before you're adding new members in there or anything like that. And you're able to essentially lay them out in the operating agreement as fees. So let's say your first deal was like an eighty twenty deal and your next deal, you're doing a seventy thirty deal with an 8% pref.

Right? So that next deal, the sponsors obviously are receiving, 30%. And so that set those sponsors will be the nonmember manager, meaning the original manager of the entity that's going through the that ten thirty one process or that exchange process might not be the same manager on the reinvestment. It might be the manager sponsor entity of the syndication entity, might be the new manager of the ten thirty one or the tick entity that's coming into the replacement property. And that's how you're able to kind of shape those economics to fit exactly what both the investors are expecting as well as the sponsors are expecting.

Chris: So Dugan, we have a deal that we brought in ten thirty one funds. And so but but it was from someone's personal, I guess, personal LLC. They already had an operating agreement for it. And, you know, it's been seasoned for a year, and so we're looking to drop them into the syndication LLC. And then, you know, eventually when we sell, we're interested in what the process is for them to be able to either ten thirty one out their separate way or to be able to take the boot.

Don't know this particular investor is going to need or want to do that, but that is a question that I've got.

Dugan K: Sure. Yeah. So the if they've if they've owned the investment for longer than a year, most conservative CPAs would say that entity is seasoned and it can essentially be rolled into another entity and theoretically receive k one. K ones are or a partnership return. Partnership, as you know, in the world of ticks and ten thirty one is kind of like a dirty word.

We don't really use that word because they're really not partners or investors. They're really co owners of undivided interest in real property. But depending on the facts or the circumstances, that entity has already been seasoned, and it does have the ability through certain structures to be put in there. But I will say this, if the investor already has an LLC, you're able to layer another LLC on top of that LLC and treat it as a disregarded entity for taxation purposes. So it accomplishes what we're talking about from a structural perspective and that's how most sponsors or syndicators that are in your position do that.

So they would essentially create a new new co LLC in which the sole equity member is the existing investors LLC, but they would become the non member manager of that that new co, and it's a disregarded entity. So it's ill it has a lot of more flexibility to play inside of the tick structure.

AJ: So so you're you're kinda saying, like, create a straw LLC to, like, hold the place for the tick to go into. So after after a year, like, the the syndication, when you form it and everything, you've got, you know, 10 investors or whatever. But having one of those investors be a new LLC that the tick then kind of, like, moves into that place in that LLC. Is that what I understand I'm hearing?

Dugan K: Yeah. So you're so I mean, you you've you've essentially got one investor who theoretically already has a an LLC and has got money ready to be to to deploy it. Right? And the question is, how how to effectively and easily smoothly deploy that capital into your next investment? Well, the easiest way is obviously through the tick structure in which in which case a new entity would be created.

You would you, the sponsors, would be the non member managers of that entity. Your investor is the is the sole member of that entity. That cash flows into the next deal. That's compliant with both the IRS as well as any lending guidelines that you're gonna feel out there with the exception of lenders that don't allow ticks. And then after after, essentially, if your investor right now has has been has held his investment for, let essentially a year, it can participate in a roll up entity depending on the structure and depending on who your lender is.

So you have lots of you have lots of lots of flexibility. We typically send out, a a draft org chart to clients to be able to show them visually because some of us are visual learners. Those of us, you

AJ: know, can see Well, you start you start getting you start getting so many people in it. It gets pretty confusing pretty quick.

Chris: Zach. So I've got a couple more questions. When you say a year, does that mean they filed taxes and then now they're filing taxes again?

Dugan K: Yeah, or they may not have I mean, it's usually remember, it's it's usually tied to the period for short term capital gains. The period for short term capital gains is is one year. So you theoretically, I guess, you could have a situation where you still haven't filed a tax return on an entity that's held interest in real property for longer than a year and the CPA says it's seasoned and it's therefore you can you can go into the next investment. We typically would defer to CPAs on that, but that's when we set when we talk about seasoning or for the held for investment time, which is what the how the treasury department or the IRS defines it, most CPAs look at that as what's the period for short term capital gains to get you into long term capital gains, and that's basically one year.

Chris: Yes. And that's the three sixty five days. It's not like Yes. If file taxes in 2023 and now you're filing for 2024, you're you've held it for a year. Like

Dugan K: You're right.

Chris: I what so, like, let's say that you bought something in 2022, and now it's 2020 it's April of twenty twenty three, and you have to file 2022 taxes. And then yeah. Well, you know, you're filing your, 2022 taxes, and you've held it. And now, you know, it's a year out until you file the next return.

AJ: Right.

Chris: Essentially, does it matter exactly when, during the year you convert the entity, essentially, you know, because your next tax return will be different.

Dugan K: Right. Of course.

Chris: Of course. But, I mean, essentially, you could do it in December and then, you know, put the entities together in January, and it's shorter term than a year, but there will be two tax returns a year apart that are different.

Dugan K: Right. I like to say that the IRS to a certain extent should look at a substance over form. So what I mean by that is not that we've gained the system by being able to form an entity file a tax return and then roll it up into a partnership entity immediately thereafter claiming that it's seasoned. The IRS is really looking at is this a commercial piece of real property? Is this something that you're that you're really trying that you're you're holding for investment?

What are the facts and circumstances surrounding it? So when we look at tax court cases because that's how most lawyers essentially look at how courts define some of these areas that that AJ said, hey, these may be gray areas or these may be areas in which CPAs might have a difference of opinion. We're trying to look at the underlying facts associated with the investment. And so we are always trying to reinforce the substance of the investment so that I mean, the intention. They're right.

The intention. Exactly. You got it right.

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Chris: Okay. And so I guess changing subjects a little bit. So when I've got two questions. One is, you know, when people want to get dropped out of an LLC and they did not ten thirty one in, are there any seasoning requirements on that drop? Or does it just you can just drop them that, you know, before closing and then they just take their boot?

Dugan K: Yeah. There that that's that's the usually people that are being dropped dropped out, they know that they're gonna pay their taxes. So it's not a it's not a tax saving device that's

Chris: Or or they can ten thirty one elsewhere. Right?

Dugan K: They they they could, but I will tell you that most sponsors, operators, syndicators, and that's typically who we represent across the country, would not like that. They don't want they don't want that to happen because that's like We

AJ: put in all this work.

Dugan K: Well, no. But yeah. But but imagine this, like, the law allows you to have up to 35 ticks in any one deal. But I will tell you practically speaking and practicing for twenty four plus years, I don't know how many hundreds or thousands of transactions I've done. The reality is most lenders are only gonna allow you like five or six.

And when and just take your deal for example. You're on the you're on the cusp. You're on the eve of going hard on a sale of an asset. If that is to happen and then the buyer wants to accelerate the closing timeline or even hit a thirty day closing timeline, you generating ballots and then splitting people out into additional entities, the cost, the overall cost of the transaction increase financially as well as the complexity of the transaction. And so you're basically I would say most operators, sponsors, syndicators are giving investors a choice of one of one choice.

The choice is this. Do you wanna ride with me on the next investment or do you wanna take your cash and pay your taxes? Because anything less, anything more than that adds additional complexity and it it potentially, challenges your ability to successfully close on the sale of the asset that you're trying to do. Now it can be done and I will tell you that Tessa and I Tessa and I have done done ticks in less than twenty four hours on deals, but it's it's like your house is on fire and you're running around with like a teacup of water trying to put it out. It's it's very, very challenging.

Chris: Okay. So that's one scenario where, you know, you've got people who have not put $10.31 exchange funds in. But now we've got, like, the other scenario where we have taken $10.31 exchange funds in and it's rolled up. And so then how do you successfully, you know, take unroll the entity with the right timing and, is that something that requires seasoning?

Dugan K: Yes. So it's I mean, again, depending on the investor. So if the investor that if the investor that came in is less than a year, theoretically, most CPAs would require seasoning. If you're simply if you're simply recreating a drop and swap of the original investors you have previously, right? That theoretically they've already been seasoned.

And again, remember the form over substance issue, it's more about intentionality and recreating that structure. But I can't really envision a scenario unless you were like, let's say you did a, you were in a traditional bridge loan, you decided to go into a HUD. Any HUD loan, you know, you're on a thirty, forty year am. So the reality is you're not popping these people out on like a, on a short term basis on something like that.

Chris: It would trying sell our properties every five years. So it's So yeah.

Dugan K: So you're little senior Yeah.

AJ: Yeah.

Chris: Go ahead. It's it's a little more, like, active than holding something for thirty or forty years. And so Okay. You know? And having taken $10.31 exchange funds in for this deal that we bought in mid twenty twenty three, you know, now we're at two years.

And, you know, honestly, you know, if if things turn around and start looking really good, we've we've done our value add for this property. Like, you know, now we're just kinda riding the market. There's potential we could sell it early, and we haven't rolled even rolled it up. And so one of AJ's big concerns there too, and I think this can be resolved by forming the higher level entity that is a an investor in the syndication, is, you know, how do we do we get our fees out of the tick? And, yeah, I mean

Dugan K: That that's easy. Your fee your fees, whether they're exit fees, guarantor fees, asset management fees, acquisition fees, construction management fees, developer fees, any type of fee that you can imagine can be memorialized either at inception in an operating agreement with a tick and be compliant with IRS guidelines or can be an amended and restated operating agreement with a a tick and still be compliant. The the difference is that in most people's mindset, the operator sponsor syndicator thinks that their fees are inextricably intertwined with their equity position. And so what I'm trying to encourage them is to think about it two different ways. One, you won't own equity in the tick entity unless you're the part of the original taxpayer.

But two, any fees that have been occurred or expected or disclosed or that the investor is expecting to pay can be memorialized inside of that operating agreement. That's whether you're you're at acquisition, in the middle of it, at exit, or at a reinvestment opportunity.

AJ: So when you say within the operating agreement,

Chris: like Same question. Yeah.

AJ: Yeah. That within the the new syndicate, like the I mean, essentially the

Chris: tick agreement between the two entities? Nope. It'll be in the

Dugan K: it'll be the operating yep. Operating agreement for the existing tick investor. So the LLC that your investor has that has an operating agreement. That operating agreement can be amended, modified, restated or if it was drafted initially it's setting forth the fees that the non member manager is charging. So in other words if every dollar of distribution that flows out the investors expecting to in our hypothetical receive 70¢, 70¢ is treated as distribution to the equity member, 30¢ is treated as a fee to the non member manager on the promote.

So instead of having distributions tied to a 30% equity stake inside of the ten thirty one or TIC investors operating agreement, your fees tied to a fee expectation. It's not unlike if you were to advertise on the internet and say, I wanna hire somebody. How am gonna pay them?

AJ: Does that So, Julian, I think that there's one kind of assumption that whatever entity is coming in with a tick is some sort of entity, not necessarily a person. But what happens in the case when the tick coming in is a actual person?

Dugan K: We have to create a disregarded entity. It's a must. Your lender is going to expect it. The IRS is going to expect it. So and when I say disregarded entity, it's a limited liability company.

A limited liability company is created. The the EIN, like the taxpayer identification number that is used for that entity is likely the Social Security number that's tied to the individual investor. And because it's a it's a disregarded entity for taxation, for ten thirty one

Chris: Member LLC. So that's different than the partner. The partner LLC needs a a partnership EIN, whereas a single member LLC is essentially just a, you know, disregarded entity. It's that has legal limited liability status. So it's not like a DBA, but or an assumed name.

Dugan K: Nope. It's it's an actual it's an actual entity that'll protect that'll that'll serve multiple functions for for them. It will provide them asset protection, in the investment. Two, it will provide essentially that safe harbor provision for the for the ten thirty one stuff. And three, for you guys, it provides you a mechanism, a legal mechanism whereby you can essentially charge the promote, the fees or mirror essentially what you would receive had they invested as an as a retail investor.

And so

Chris: we're helping them form their operating agreement and inserting us as a non member manager for that LLC. And you were mentioning the, you know, the layered LLC up above Right. The you know, that disregarded entity, And that is a function to roll up by having that second LLC own a 100% of the disregarded entity.

Dugan K: Yeah. Wouldn't need that. You wouldn't need that unless the original tax payer was an entity. If the original taxpayer, the original investor is an individual, they won't need that multiple layers because you'll be able to set up your fees and all of that right up up front. If if they are if they are a an entity investor meaning they currently hold their investment as an LLC and the LLC is recognized with an EIN and it's recognized for IRS purposes as the original taxpayer, your lender likely is going to require a new LLC to be formed to sit on top of that.

That can be treated as a disregarded entity. And the reason why is every entity has a history. Even if you if you promise, you swear on a stack of bibles with your lender, hey, this I've never done anything bad with this LLC ever. They just don't wanna take upon themselves the contingent liability associated with that. So that layering effect allows the lender to remove any contingent liabilities that may exist with that entity investor, but it also allows you the same mechanism that you would have if it was an individual investor and you were gonna form a new entity for them.

You you were gonna give them an operating agreement, you were gonna insert yourself as the non member manager, you were also going to put your fee schedule in that operating agreement. Both of them allow you the same mechanism to achieve the same objective.

AJ: And I'm sorry, but I'm I'm I get into the weeds here very much. But when you're kind of, like, moving that moving that around and and creating these disregarded entities, I understand, like, at the beginning, it's it's you create that, but you season it for a year. What is is it a transfer, a sale? Like, how how does it actually move into the new disregarded entity or roll up? Like, what what sort of function or how would you describe that?

The paperwork.

Dugan K: Depending on depending on the state where the where the entity is is located, where it's formed, it can be as simple as amending and restating the operating agreement. It can also be done through a simple conveyance, meaning it's just an assignment of interest or an assignment of membership rights. It can be an actual purchase and sale agreement that exists between the new entity and the old entity. Any number of We

AJ: often use quick claims. When you say commands, is that like a quick claim into? So it's like a, we, we often there's, there's one form that we use that's like, oh yeah, we messed up the name and this is a quick claim into the right name.

Dugan K: Right. Quick claim deed, special warranty deed, general warranty deed. All of those are three ways in which you can convey a piece of real property to another, entity at any given time. Quick claim just means, hey, you're just getting whatever I have. I'm not giving you any warranty or representation as to what I have.

I'm just putting it in there. We use that a lot of times in in real estate transactions where you're where you've got a the legal description is different on the updated survey from what the vesting deed is. And so you might have a transaction where you'll have a special warranty deed or a general warranty deed and also a quick claim deed in the same transaction. But you're right. That's just a form of conveyance.

AJ: Okay.

Tessa: So

Chris: I guess when we're dropping people out of an LLC so that they can take boot, how like, can we just give them the cash and say that, you know, they're or is it we're needing to drop them out, assign a certain dollar amount to them, and then they take their their boot?

Dugan K: Yeah. So what your the mechanics of it are remember, back to original hypothetical, we send out a ballot to our investors. We now have two camps. We've got the camp of the people that want the exchange and the camp of the people that don't want the exchange. The people that don't want the exchange are being dropped into a new limited liability company.

Same same structure as that exists in the exact ownership. You're just your cap table is changing, meaning you're gonna have to do some math on what their percentage of that new entity is owned such that now from a title company's perspective, all they really care about is what's this you gotta let's say you're you're you're gonna get a million dollars in gain on the sale of this property. The title company is gonna say, okay, guys, what percentage goes to this entity and what percentage goes to this entity? And then on the statement, on your HUD or your settlement statement, it's gonna have disbursements that will flow out. One will be to a qualified intermediary of, let's say it's 50.

Let's just make it easy math.

Chris: $100,050.50.

Dugan K: Yeah. 500,000 is going to this QI on behalf of the seasoned entity that that continues on with the investors who want to go through the exchange and 500,000 is being distributed over here to NewCo associated with that. So that's the that's the way that it's that it's usually works.

Chris: Okay. Awesome. That makes a lot of sense. And then the, you know, the new company will receive the money and then distribute it as it pleases.

Dugan K: They're gonna you're gonna issue you're gonna issue final k ones from the new company to your partner, to your investors, just like just like you have all of the other years. Right? That new company is gonna file a final tax return. I usually tell clients, I said before you dissolve a a company or certainly before you kick out 100% of all the distributions, hold back some a little amount of a contingency, right, for to wash payables and your receivables through the system.

AJ: Do you any suggestion on, like, kind of, like, what sort of amount or what sort of percentage to hold back?

Dugan K: Yeah. It kinda depends on the size of the scale. Right? So common sense, if it's if we're talking about a $50,000,000 office building with multiple tenants and 50

AJ: We're not we're not that big. We're not that big.

Dugan K: I get it. But like so you're so you're probably I would say you're gonna hold back $510 probably to wash through the system depending on what your CPA is gonna charge on the final thing. Because I've had clients, unfortunately, they've had to do, clawbacks or they've had to ask the investors who receive distributions, please give us money back because we don't have enough money to actually wind down the the company after we've sold the asset, and the company no longer serves any purpose for its existence. Well, what if you don't wanna be put on position?

Chris: Funds forward, and they're, you know, locked up in with the

AJ: intermediate The swap, you're not winding down. It's just the when the the drop in the boot is a new LLC that you you wind down and and and close.

Chris: There could be outstanding bills that just come up. You know? Right. A contractor appears Yep. Who says they're owed, you know, six digits.

And That's right.

Dugan K: That's why there's that's why typically what you want, even if you're the exchange entity, you're gonna wanna have a title company that you that understands the tick process and that they're that they will withhold and not distribute 100% of all the proceeds to the QI. So they will withhold a certain percentage to, again, wash wash out whatever the the true up is on any bills that are outstanding. So, on both sides. Right? Because otherwise, what happens is you're gonna you're gonna eventually have to make a dish you're gonna have to inject new capital into that exchange entity to pay the bills because you've washed 100% of whatever those that money is from the title company into the QI.

So you're you the math is real important here. Right? So the math on both the cap tables as well as the percentages of what you're gonna get on those distributions is is super important. And being able to forecast what your what your your what your outstanding bills are from a from a an accounting perspective.

AJ: And and, Dugan, I another question that, like, kind of, like, comes to my mind with, you know, exchange and and companies and everything like that. I mean, like, what what do we do with the operating account? Like, I mean, we've usually got, you know, $10.10 to $30,000 in the operating account. Like, do we, you know, send that to the escrow company and say this is part of the exchange going forward, or do we just

Dugan K: You can, but remember that's already after tax dollars. Meaning you've already, since you've touched it, it's in your operating account. I wouldn't kick it into title. You may be transferring part of that operating account to the new co depending on that percentage because they rightfully own a piece of whatever that those funds are that's in your operating account. So you'll be moving transferring between accounts some of that money depending on the percentage of undivided ownership interest in the in the new entity that you're setting up.

AJ: I guess we could probably just take that as use that money to pay our fees. So are

Chris: there any money handling, I guess, no nos when it comes to transfer? I mean, obviously, there's the big you know, you can't touch any of the proceeds from the sale. Right. But are there any other money money handling, like, rules that need to be observed?

Dugan K: That that's the big one. Then we just we revert to what where mom has told us. Don't lie, cheat, or steal. Right? Other than that, that's just we just wanna make sure that we're just we're we're just making sure that we don't touch that money that's coming from the title company.

Chris: And then what like, if if we're holding back funds from the qualified exchange to what to make sure that we've got money for bills, like, let's say that we held too much. Is that that's just taxable funds at this point?

Dugan K: That's right.

Chris: So Yeah. And and so the exchange group will get a distribution of taxable funds. So that's that's a possibility. Like, in the money in the operating account too, that will be a distribution to all the investors and everyone's gonna have to pay taxes on those.

Dugan K: Yeah. But it's just some it's a little bit it's a little piece of what we call boot. Right? So, like, you're not really and it's not even a rounding error, usually on on these things. It's more important from your perspective to make sure that you have ample funds to take care of all the bills associated with the transaction than it is, then investors are gonna expect that.

Remember that going into the investment, they were never guaranteed not paying taxes. So there's not an expectation that they're not gonna have to pay some form of taxes associated with with the process.

AJ: Dugan, we really appreciate your time, and I know that we're we're coming up on the, hour mark here. Is are there any questions that you think we should be asking right now?

Dugan K: I don't think so, man. We've exhausted this this this thing. You guys are extremely deep. You guys went real, real deep into my bag of tricks to to get all this stuff out. But I I really am a big believer in this, guys.

I really am a big believer in providing diversified streams of income or capital to sponsors, operators, and syndicators. So people out there that are are scared or that they're afraid of doing, ticks or trying it, I just say you're you're you're you're harming yourself from a a massive opportunity to garner an independent stream of capital. So the tick investors largely think of about investing different than people that are investing with after tax dollars. In some ways, it's often easier. So I'm a big believer in it.

I'm encouraged by it. I mean, there's billions and billions of dollars that will be exchanged this year via ten thirty one. It's my favorite part of the tax code. So I'm I'm glad that you guys are are in the investing game and that you're offering this to your investors. It's super important.

Chris: I really love how you describe the, I guess, tick investment as a stream of income, as as a separate stream that flows into a bigger river and something that should be considered being built by, you know, an investor. And I think that it will definitely use that idea. I I I do really like it, and we'll I'll make sure that you get the the credit for

Dugan K: Alright. I'll take it.

Chris: Planting that little seed in our head. Yeah. That I've it's it's been really, really awesome to to get your knowledge on this, and we look forward to working with you too. Alright. So we'll, we'll send you some stuff.

We're looking at a deal yesterday and, yeah, exciting times.

Dugan K: Alright. Thanks, guys. Appreciate you.

AJ: Yeah. Thanks for for coming on our podcast. Of course. Anytime.

Okay. Cool. Awesome. Thank you, guys.

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