When a partnership owns real estate, a time may come when some of the partners want to walk away. When this happens, disagreements can (and often do) break out about an exit strategy. For instance, some partners may want to sell and cash out. Others, knowing that there will be a taxable event, may want to roll any tax gain into a new property through a 1031 exchange.
Before choosing how to proceed, partners should consider the potential tax pitfalls of their economic and investment decisions.
Allocating boot gain when some partners want to receive cash instead of reinvesting in replacement real estate requires special planning in order to adhere to the complex “substantial economic effect” rules. Under these rules, a partner needs to be liquidated in accordance with his/her tax capital account balance. If a partner will be allocating gain to the extent of cash received (i.e. the boot) the capital account balance may not zero out, causing a potential reallocation of some of the gain to other partners.
For example, assume A, B & C are equal partners in ABC LLC. ABC owns a building with a value of $18M subject to $9M in debt and an adjusted tax basis of $6M. If sold for cash, each partner would be allocated their 33% share of the $12M gain or $4M. However, if only A and B want to roll their investment into a new property, a new property may be purchased. However, $3M in cash (($18M – $9M) / 3) will need to be distributed to C. Since C has a deficit capital account of ($1M) before the transaction, the distribution and allocation of boot gain (each $3M) would keep his capital at ($1M) upon redemption from ABC with the possibility of having an additional gain recognized equal to this negative capital. However, when looking at the liquidating distribution, C would increase his/her capital to $2M from the boot gain allocation but receive a $3M liquidating distribution. This would not be in accordance with his/her capital account.
Tax Law Disallowing Tax-Free Exchange of an Actual Partnership Interest
The transaction would be simplified if A & B could just exchange their interest in ABC for a new partnership interest while C sells his/her interest for cash. However, partnership interests are expressly prohibited from being exchanged tax free.
Strategies to Avoid Tax Pitfalls
One strategy would be to look at the balance sheet of the selling partnership to determine if a cash out transaction would pass muster under the “substantial economic effect” rules. Certain transactions where there is additional boot from a reduction of replacement debt would allow C to liquidate in accordance with his/her capital account. Using the above example, if the replacement property is acquired subject to only $8M in debt, the boot gain would be increased to $4M which would all be allocated to C who will then increase his/her capital to $3M and receive a $3M liquidating distribution. This should work from a tax perspective but could turn into an uneasy conversation about how the partner now has $4M in gain on $3M in cash. The response should be that the additional gain is effectively the recapture of the benefit previously enjoyed for depreciation deductions taken prior to the redemption, which presumably reduced prior tax bills without any cash outlay or prior distributions of refinancing proceeds resulting in deferred gain.
Another strategy that can be employed is the use of Tenant In Common interests or TICs. A TIC is a subdivision of a property for tax and legal purposes. A, B & C may own a building as TIC owners if they meet the requirements and not be deemed to own an actual partnership interest. A TIC interest in real property is an asset that is a direct ownership interest in real property that can be exchanged under Section 1031. Where A, B & C have owned their real estate through a TIC, AB could exchange their respective TIC interests for another property while C sells his/her TIC interest for cash. The use of TICs are governed by strict rules that must be adhered to so that the tax authorities do not recast the transaction into a partnership structure instead of a TIC structure.
A third potential strategy is the use of an installment note paid to the partnership from the buyer in addition to cash paid to the 1031 Qualified Intermediary. The note will then be distributed to C in liquidation of C’s interest in ABC. Gain on liquidation could be deferred until note is paid and therefore effectively the “boot” is allocated to C.
When entering a real estate partnership, it’s wise to consider all of these factors and do partnership “prenup” planning to fully explore the ramifications of a possible breakup down the road. This way, all parties can be sure their interests are protected.