A version of this article was published in the October 2023 edition of the Colorado Real Estate Journal.
For property owners looking to build and enhance wealth, compounding internal rates of return on the tax deferral of real property assets can be a powerful tool.
Upon the proposed sale of a real estate asset, organizers of real estate partnerships frequently find that there are two types of investor groups, one that prefers liquidity in a cash out transaction, and another that would rather engage in a like-kind exchange.
Each investor group type has different financial goals, and satisfying both, while simultaneously navigating the complexity and potential obstacles of like-kind exchange rules can be challenging. Below are some solutions and considerations.
Common Like-Kind Exchange Obstacles
Obstacles within the like-kind exchange rules typically include the following.
Continuity of Taxpayer Rule
The taxpayer who sells the relinquished property must also be the taxpayer that acquires the replacement property. Partnerships are considered taxpayers for purposes of this rule.
Qualified Use/Held for Requirement
Both the relinquished and the acquired real property must be either held for productive use in a trade or business or held for investment in real property.
Common questions related to this requirement typically include the required length of the holding period after acquisition. This is because the held for requirement isn’t clearly defined in Internal Revenue Code (IRC) and therefore has been subject to IRS litigation.
Some like-kind exchange practitioners declared the held for challenges dead after favorable taxpayer rulings, including Magneson v. Commissioner, 81 T.C. 767 (1983) and Bolker v. Commissioner, 81 T.C. 782 (1983). However, the codification of the economic substance doctrine, combined with potential accuracy or disclosure-related penalties, are incentives for taxpayers to remain conservative about the duration of the holding period.
Special Allocation of Gain
A like-kind exchange that involves debt relief or the receipt of cash from the relinquished to the acquired property will be treated as gain recognized, referred to as “boot.”
A special allocation of this gain to the partner who received the cash must be an allowable allocation under the terms of the operating agreement and the economic substance requirements.
Frequently the cash received from the accommodator is used to redeem investors. Investors will generally have a positive capital account; therefore, the amount of the boot or gain recognized will likely exceed the desired gain to bring the redeeming partners’ book capital account to zero.
Partnership Structuring Options
Fortunately, potential structuring opportunities can help mitigate some of the potential obstacles.
Partnership divisions require careful up-front planning to execute properly.
The partnership, prior to signing a purchase and sale agreement, will formally divide the partners into two groups:
- Those who want to continue with the existing partnership
- Those exiting who desire liquidity
The formal steps to a partnership division often include:
- The manager or general partner approves a plan of division which includes, identifying partners who wish to continue in the partnership, referred to as OldCo, or exit the existing partnership, ExitCo, and drafts a preliminary operating agreement for the resulting partnership.
- The original partnership forms a new entity, ExitCo, to serve as the resulting partnership, which will ultimately be composed of the retiring partners.
- The original partnership will retain at least a 50% interest in the profits and capital of the new entity, ExitCo, and therefore the new partnership will be considered a continuation of the previous partnership under the partnership division rules of IRC 708(b)(2). Only the partnership with the greatest fair market value (net of liabilities) will inherit the tax identification number and certain other tax attributes of the partnership.
- The original partnership, OldCo, will divide the assets and liabilities of the partnership according to the liquidation provisions of the operating agreement utilizing either the asset-over form or assets-up form. The real property will be retitled and held as tenants-in-common between the resulting partnership and the divided (original) partnership.
The same taxpayer rule is achieved by utilizing the divided partnership to move forward with the like-kind exchange with the continuing partners.
The partnership division strategy can have many benefits, which include utilizing a lower acquisition price of the replacement property. The price must be greater than or equal to the selling price of the divided partnership’s relinquished property.
Part-Exchange/Part-Installment Sale and Distribution of Installment Sale Note
Partnership division strategies are often elusive because identifying or acquiring the replacement property prior to sale may be difficult in volatile market conditions.
For this reason, alternative strategies may be more appealing. One of the alternative strategies is the use of an installment sale with a note to the partners wishing to retire.
The exiting partners will continue to be considered partners of the existing partnership until the installment sale note and redemption payments to exiting partners in liquidation of their partnership interest is fully satisfied.
The formal steps to a partnership part-exchange and part installment sale note typically include the following steps:
- The partnership executes a contract with a third party to sell real estate to a buyer for cash and a promissory note.
- This sale contract is assigned to a qualified like-kind exchange intermediary (QI) with terms that the buyer transfers the cash to the QI and the promissory note to the partnership.
- The debt encumbering the property prior to the sale is satisfied.
- The partnership then distributes the promissory note to the exiting partner(s) in redemption of their partnership interest with terms for providing for full liquidating payment in two taxable years or less.
- Alternatively, instead of a promissory note with a third party, the QI may issue an installment sale note to the partnership for the amount the exiting partner is to receive; the partnership then distributes the qualified intermediary note to the exiting partner(s).
Frequently Evaluate Tax Planning Opportunities
Due to the complex nature of partnership divisions in conjunction with Section 1031 transactions, it’s important to plan and model proposed scenarios prior to entering the Section 1031 exchange.
Section 1031 exchanges employ a compressed time frame for relinquishment and identification of replacement properties. In these constantly changing real estate market conditions, timing is critical to close these complex transactions.
To avoid triggering unexpected taxable gain or avoid unintended tax consequences, the use of a tax advisor and legal counsel is imperative.
We’re Here to Help
For more insights on how to navigate the rules surrounding like-kind exchange transactions, contact your Moss Adams professional.