Partnership Like-Kind Exchanges

Transcription

1 Partnership Like-Kind Exchanges By Norman Lencz, Esq. Venable, LLP Christopher Davidson, Esq. Venable, LLP 225

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3 PARTNERSHIP LIKE-KIND EXCHANGES Maryland Advanced Tax Institute Norman Lencz Chris Davidson November 6, 2014 INTRODUCTION Section 1031 like-kind exchange. Ability to defer taxable gain if sale proceeds are rolled over er into like-kindkind property. One of the last remaining tax loopholes that is not on the government s chopping block. Most commonly used for real estate. Like-kind property is broadly defined in real estate context. t Deferred exchanges through a QI (qualified intermediary). 227 (#) 1

4 INTRODUCTION Real estate is usually held in limited liability entities (LLCs or partnerships). Under IRC Section 1031(a)(2)(D), partnership and LLC interests cannot be swapped in a tax-free like-kind exchange. Thus, the partnership/llc must be the party that sells the relinquished property and acquires the replacement property. But what if some partners want to engage in a like-kind exchange and some want to cash out of their investment? CASE STUDY Adam, Beth, and Chris are equal partners in ABC LLC, which owns a building with a FMV of $15 million and a basis of $5 million. Adam received his interest very recently in exchange for a contribution of $5 million, so he has a $5 million basis (i.e., fully stepped-up basis) in his interest. Beth and Chris, who have been members of ABC forever, each have a basis of zero in their LLC interests. 228 (#) 2

5 CASE STUDY A buyer has made an offer to purchase the building for $15 million. All of the members want to sell, but Adam, who has a stepped-up basis, wants to cash out, while Beth and Chris want to defer their taxable gain on the sale by acquiring likekind property under IRC Section If ABC sells the building for $15 million, rolls over $10 million of the proceeds into like-kind replacement property (through a QI)anddistributestheremaining$5millionincashtoAdam, ABC will recognize $5 million of gain on the transaction (i.e., gain is recognized to the extent of the cash boot). If the $5 million of gain is allocated pro rata to all of the members, Beth and Chris would each recognize $1.67 million of gain, but would receive no cash clearly, an undesirable result. POTENTIAL SOLUTIONS There are potentially 5 alternatives for dealing with this situation: 1. Special Allocations 2. Distribution of Undivided Interests 3. Installment Note 4. Redemption of Interests 5. Coordinated Like-Kind Exchanges 229 (#) 3

6 OPTION 1 SPECIAL ALLOCATIONS Can gain be specially allocated to those members who are being cashed out? Issue has not been addressed in any federal court cases or rulings. California State Board of Equalization (SBE) addressed d the issue in Appeal of Ahlers, Cal. St. Bd. Ed. No , December 31, OPTION 1 SPECIAL ALLOCATIONS Allocations must have substantial economic effect ( SEE ) 2-part test Economic Effect o Maintain capital accounts in accordance with Treas. Reg. Section (b)(2)(iv); o Liquidate in accordance with positive capital accounts; o Either (1) require partners to restore negative capital accounts upon liquidation or (2) have a qualified income offset ( QIO ) provision. 230 (#) 4

7 OPTION 1 SPECIAL ALLOCATIONS Allocation is substantial if: There is a reasonable possibility that the allocation (or allocations) will affect substantially the dollar amounts received by the partners independent of the tax consequences; and At the time the allocation becomes part of the partnership agreement, the following is not true: o The after-tax economic consequences of at least one partner may, in present value terms, be enhanced compared to such consequences if the allocation (or allocations) were not contained in the partnership agreement, and o There is a strong likelihood that the after-tax economic consequences of no partner will, in present value terms, be substantially diminished compared to such consequences if the allocation (or allocations) were not contained in the partnership agreement. OPTION 1 SPECIAL ALLOCATIONS How would special allocations work? In our case, Adam, the member who wants to cash out, would be allocated $5 million of gain. This would increase his basis to $10 million. On the receipt of $5 million in liquidation of his ABC interest, he would have a $5 million capital loss to offset the allocation to him of $5 million of gain. Where all the gain is capital gain, the loss on liquidation would completely offset the allocated gain. This would not be the result, however, if some or all of the gain was depreciation recapture. 231 (#) 5

8 OPTION 1 SPECIAL ALLOCATIONS Would the special allocation to Adam have economic effect? Presumably not, because the special allocation would increase Adam s capital account from $5 million to $10 million and, therefore, the liquidation of his interest for $5 million would not be in accordance with his $10 million capital account. But is this the case in all circumstances? What if Adam s capital was zero at the time of sale? ABC distributes a 33 1/3% undivided tenancy-in-common ( TIC ) interest to Adam, and retains a 66 2/3% TIC interest. Adam then sells his TIC interest for $5 million of cash. The LLC swaps its 66 2/3% TIC interest (through a QI) for $10 million of like-kind replacement property. 232 (#) 6

9 Issues: Is held for requirement satisfied? Will TIC interests be recharacterized as partnership interests? Will the distribution be disregarded under step transaction principles? p Property swapped in a like-kind exchange must be property that is held for use in a trade or business or for investment. This requirement applies to both relinquished and replacement properties. Property that is acquired in a taxable transaction with an intent to immediately be resold would not satisfy this requirement. 233 (#) 7

10 Does acquisition of property immediately before or after a like-kind exchange in a non-recognition transaction violate the held for requirement? IRS has historically challenged these transactions. See, e.g., Rev. Rul , Rev. Rul and Rev. Rul The courts, however, have generally been more liberal. See, e.g., Magneson and Bolker. This issue arises in the context of tax-free contributions to partnerships under IRC Section 721 and tax-free distributions from partnerships under IRC Section 731. Under IRC Section 1031(a)(2)(D), partnership interests cannot be swapped in a like-kind exchange. Therefore, if the TIC co-ownership arrangement is recharacterized by the IRS as a partnership, the sale of the TIC interest by ABC will not qualify for tax deferral. A partnership is more likely to be found if there is a significant level of activity involved in the operation and management of the property. Triple-net leased TIC property will generally not be recharacterized as a partnership Rev. Proc provides a de facto safe harbor. 2 (#) 8

11 Rev. Proc Criteria Tenancy-in-Common Ownership. Each of the coowners must hold title to the property (either directly or through a disregarded entity) as a tenant in common under local law. Number of Co-Owners. The number of co-owners must be limited to no more than 35 persons. No Treatment of Co-Ownership as an Entity. The coownership may not file a partnership or corporate tax return, conduct business under a common name, execute an agreement identifying any or all of the coowners as partners, shareholders, or members of a business entity, or otherwise hold itself out as a partnership or other form of business entity. Rev. Proc Criteria Co-Ownership Agreement. The co-owners may enter into a limited co-ownership agreement that may run with the property. Voting. The co-owners must retain certain voting rights, and certain actions must be by unanimous approval of the co-owners. Restrictions on Alienation. In general, each owner must have the right to transfer, partition, and encumber his undivided interest in the property without the agreement or approval of any person, although certain exceptions apply. 235 (#) 9

12 Rev. Proc Criteria Sharing Proceeds and Liabilities upon Sale of Property. If the property is sold, any debt secured by a blanket lien must be satisfied and the remaining sales proceeds must be distributed to the co-owners. Proportionate Sharing of Profits and Losses. Each coowner must share in all revenues generated by the property and all costs associated with the property in proportion to his undivided interest in the property. Proportionate Sharing of Debt. The co-owners must share in any debt secured by a blanket lien in proportion to their undivided interests. Rev. Proc Criteria Options. A co-owner may issue a call option to purchase his undivided interest, provided that the exercise price for the option reflects the FMV of the property. A co-owner may not acquire a put option to sell his undivided interest to the lessee, another coowner, or the lender, or any person related to the lessee, another co-owner, or the lender. No Business Activities. The co-owners activities must be limited to those customarily performed in connection with the maintenance and repair of rental real property. p Management and Brokerage Agreements. The coowners may enter into management or brokerage agreements with an agent, who may be a co-owner, but who may not be a lessee. 236 (#) 10

13 Rev. Proc Criteria Leasing Agreements. All leasing arrangements must be bona fide leases for federal tax purposes, and all rents paid by a lessee must reflect the FMV for the use of the property. In general, the determination of the amount of the rent must not depend, in whole or in part, on the income or profits derived by any person from the property leased. Loan Agreements. The lender with respect to any debt that encumbers the property or with respect to any debt incurred to acquire an undivided interest in the property may not be a related person to any co-owner, the manager, or any lessee of the property. Payments to Sponsor. Except as otherwise provided above, the amount paid to a sponsor for a co-ownership interest (and the amount of any fees paid to a sponsor for services) must reflect the fair market value of the acquired interest (or the services rendered) and may not depend, in whole or in part, or the income or profits derived by any person from the property. Will the distribution be disregarded under step transaction principles? If ABC signs the sales contract prior to distributing the TIC interest to Adam, the IRS could, in reliance on Court Holding Company, ignore such distribution and characterize the transaction as an exchange of all of the property by ABC. Under this line of reasoning, Adam s receipt of $5 million would be taxable boot to all of the members. If the distribution occurs after an LOI has been signed, but before a binding contract has been signed, the risk of recharacterization should be minimal. Following of all legal formalities with respect to the distribution (e.g., obtaining necessary lender consents, recording the deed of transfer) is essential. 237 (#) 11

14 OPTION 3 INSTALLMENT NOTE Partnership exchanges the relinquished property for cash to purchase replacement property and the buyer s installment t note. Partnership keeps the replacement property and distributes the installment note to the cash-out member. In our example, ABC would sell the building for $10 million of cash (which would be paid to a QI) and a $5 million note from buyer which would be distributed by ABC to Adam. OPTION 3 INSTALLMENT NOTE The note would provide for almost all (e.g., 99%) of the payments thereon to be made shortly after closing. Remaining payments would be made after the beginning of the next taxable year, allowing the note to qualify for installment reporting under IRC Section 453(b)(1). If buyer s creditworthiness cedt ot essis an issue, a standby letter of credit could be obtained to secure buyer s obligations under the note. See Treas. Reg. Section 15A.453-1(b)(3). 238 (#) 12

15 OPTION 3 INSTALLMENT NOTE In our case, no immediate gain to ABC on receipt of the note under Section 453 (subject to exceptions such as sales of inventory and depreciation recapture). ABC would take a $0 basis in the note (ABC s $5 million of basis will be assigned to the replacement property). Prop. Reg. Section (f)(1)(iii). The note would be distributed to the cash-out member, Adam, in liquidation of his interest. OPTION 3 INSTALLMENT NOTE Distribution of the note should not result in gain to ABC or any of the members. Treas. Reg. Section (c)(2). Adam will take a $5 million basis (i.e., basis equal to his outside basis) in the note under IRC Section 732(b). Because the basis of the note increases as a result of the distribution, a basis step-down should apply to ABC s assets (i.e., e the replacement property). Adam should have no gain as note payments are received. 239 (#) 13

16 OPTION 3 INSTALLMENT NOTE If Adam s outside basis is less than the principal amount of the note, Adam would recognize gain as payments are received. Step transaction concerns? What if buyer is unwilling to issue a note? What if ABC (or Adam) does not want to accept buyer s note (even with a standby letter of credit)? Query whether ABC could accomplish the same result by having the QI issue the installment note, provided that the note is not collateralized with cash or other liquid assets. OPTION 4 REDEMPTION OF INTERESTS Option 3 above, the installment note method, requires the involvement and cooperation of the buyer, who pays a portion of the purchase price with an installment note. Alternatively, ABC in the above example can redeem Adam s ABC interest prior to the sale to the buyer. The redemption can theoretically occur the same day as the sale, as long as it occurs prior to the sale. As a practical matter, the redemption usually occurs some time prior to the sale. 240 (#) 14

17 OPTION 4 REDEMPTION OF INTERESTS How will the redemption of Adam be funded? The LLC and/or the remaining members will often be unable or unwilling to lay out the cash necessary for the redemption, particularly if there is some uncertainty as to whether the sale transaction will actually close (e.g., will all closing conditions be satisfied?) OPTION 4 REDEMPTION OF INTERESTS ABC could issue Adam a note in redemption of his interest, payable at closing. Adam will presumably want the redemption note secured by the property, which increases complexity and costs. Note that use of this method would require ABC to purchase replacement property equal in value to the entire property, rather than just 2/3 of the value of the property. 241 (#) 15

18 OPTION 5 COORDINATED EXCHANGE Solution for situations where all of the members want to do a like-kind exchange, but cannot agree on the replacement property to be acquired. For example, assume that on ABC s sale of the building, each of Adam, Beth, and Chris would like to undertake a like-kind exchange, except that Adam wants to acquire Property A, Beth wants to acquire Property B, and Chris wants to acquire Property C, each of which costs $5 million. OPTION 5 COORDINATED EXCHANGE ABC could sell the building and form three separate single member LLCs one for Property A ( ALLC ), one for Property B ( BLLC ), and one for Property C ( CLLC ). Adam, Beth, and Chris could be appointed managing member of ALLC, BLLC, and CLLC, respectively; After holding the properties for a significant period of time (preferably, at least two years), ABC could be liquidated, and pursuant thereto, ALLC would be distributed to Adam, BLLC would be distributed to Beth, and CLLC would be distributed to Chris. 242 (#) 16

19 OPTION 5 COORDINATED EXCHANGE During the time ABC held the three properties, ABC would specially allocate income, loss and gain from the properties to reflect the desired d economics. However, this structure only works if ABC is treated as the tax owner of all three replacement properties. Thus, Adam, Beth, and Chris will have to share in the economic performance and the appreciation (or depreciation) of each of the properties in a meaningful way. For Further Information Norman Lencz Chris Davidson Venable LLP Venable LLP Baltimore, MD Baltimore, MD nlencz@venable.com csdavidson@venable.com 243 (#) 17

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