How to Sell Real Property Tax-Free From a Partnership – October 2015
The taxes imposed on the sale of real property can be high and discourage that property’s sale from occurring.1 However, with proper planning and structuring, real property can be sold and transferred tax-free from a partnership or limited liability company.2 A number of creative tax planning structures can be employed, including Section 1031 tax-free exchanges, leveraged partnership transactions under the partnership tax law rules, and the use of the tax-free partnership division rules.
The President in the past year has proposed tax law changes in an effort to prevent taxpayer’s use of some of these tax planning techniques.3 However, fortunately none of these tax law changes are likely to be enacted in the foreseeable future. Below is a discussion of some of these tax planning techniques.
How Different Partners Can Acquire Different Properties in a Section 1031 Tax-Free Exchange.
Many times partners will desire to sell a property and for different groups of partners to purchase different properties, or for only certain partners to be cashed out. These goals can be accomplished by first liquidating and terminating the partnership and having the partnership’s real property distributed to the partners as tenants-in-common. The former partners then must hold the real property as tenants-in-common for a substantial period of time so that they evidence their intention to hold that liquidated real property for investment. This planning technique is often referred to as the “drop and swap” plan.
In order for this tax plan to work: the former partners after the partnership’s liquidation must be titled on the recorded property’s deed as tenants-in-common; any loans secured by the property must be changed over to the new tenants-in-common; vendors, insurance companies and tenants must be notified that the partnership no longer exists and that rent payments are to be made to the new tenants-in-common; and the partnership must be formally liquidated and terminated under state law. It should be evidenced that the new tenants-in-common (who were the former partners) intend to hold the real property for investment purposes.4
While the tenants-in-common own and operate the real property, it is important that the tenancy-in-common relationship not be classified as a partnership for federal income tax purposes.
How to Cash Out Some Partners, While Allowing Other Partners to Engage in a Tax-Free Section 1031 Exchange into a New Property.
Under this plan, the partnership sells to a third party buyer the partnership’s real property for cash plus a promissory note. The cash is retained by the partnership and utilized by the partnership to engage in a Section 1031 tax-free exchange into other real property. Those partners wanting tax-free exchange treatment remain in the partnership, and the partnership then proceeds to purchase other replacement real property in the tax-free exchange. The promissory note immediately after the closing of the sale of the partnership’s relinquished property is then distributed only to those partners (in complete redemption of their partnership interests) who desire to receive cash and pay tax on that received cash. The promissory note is paid to the cash-out partners over two tax years. To provide security for the promissory note’s payment, the promissory note is often secured by either a first deed-of-trust or a standby letter-of-credit.
Thus, under this plan only those partners desiring to engage in a Section 1031 tax-free exchange into a new replacement property remain in the partnership, while those partners who desire to receive cash receive the promissory note and recognize taxable gain.
Have a Tax-Free Division of the Partnership into Two New Partnerships, Followed by Each of These New Partnerships Selling Their Respective Properties, and Using the Sale’s Proceeds to Exchange Tax-Free into Different Properties.
If a partnership owns a real property and desires to sell that real property, but the partnership is owned by two groups of partners with each group wanting to exchange into different real properties (or possibly one group of partners wanting to retain cash in the property’s sale), then consider utilizing the tax-free partnership division rules. Under the tax-free partnership division rules of Section 708 each of the new resulting partnerships must be a “continuing partnership” for federal income tax purposes, which will require each new continuing partnership’s partners to have owned at least 51% of the profits and capital of the terminating partnership. This may result in all partners having to own at least some small percentage of each of the new continuing partnerships. However, as a second step in this transaction, some of the partners can be bought out of each of the continuing partnerships at a later date in order that each continuing partnership is then owned by only one group of partners. It is important that each of the continuing partnerships succeeds to the tax attributes of the original terminating partnership, including the fact that each continuing partnership has “held” the sold real property for trade or business or for investment purposes.5
Another use of the partnership division rules is to split up tax-free a partnership which owns multiple properties by having different properties allocated to different groups of partners.
Have the Partnership First Borrow Monies, Followed by the Partnership Purchasing Other Property. The Partnership Then Distributes Such Newly Acquired Property Tax-Free to Only Certain Partners in Full Redemption of Those Partners’ Entire Partnership Interests.
As an example, a partnership owns an office building with only certain partners wanting to continue to own that office building, while another group of partners desires to purchase a new property. The partnership could first borrow monies (from an outside lender). These borrowed monies (along with other partnership monies) could then be utilized by the partnership to purchase a new real property which is then distributed to only certain partners’ in complete redemption of these partners’ partnership interests.
The result of this plan is that one group of partners remain owners of the partnership with the original office building, while another group of partners receives a tax-free distribution of a newly purchased real property. This transaction must be structured to avoid violating the partnership tax rules on disguised sales, and to satisfy the partnership debt allocation rules.
If a Partner Should Die (and for Community-Owned Partnership Interests Should that Partner’s Spouse Die), then the Partnership Can Make a Section 754 Tax Election to Receive a Step-up in the Partnership’s Property’s Income Tax Basis, Thereby Enabling the Partnership to Sell the Partnership’s Property at a Reduced or No Tax Cost.
If a partner (or a partner’s spouse for community-owned partnership interests), should die then that partner’s partnership interest receives a step-up in its income tax basis to its fair market value as of the date of death. If the partnership in the year of death then makes a Section 754 tax election the income tax basis of the partnership’s property also receives a proportionate step-up in its income tax basis, resulting in the reduction or elimination of taxable gain when that property is sold by the partnership.
Using Real Estate Investment Trusts to Transfer Real Property Tax-Free.
Partnerships and other property owners who want to transfer real property tax-free, can utilize an “UPREIT” structure with a real estate investment trust (known as a “REIT”). A REIT is a specially organized legal entity which owns real property, and if certain tax requirements are met there is no tax on the REIT’s income at the REIT entity level. Under an UPREIT structure the property owner transfers real property into a real estate limited partnership (sometimes referred to as the “Operating Partnership”) under which the publicly traded REIT is the general partner. The property owner receives back limited partnership interests (often referred to as “OP Units”) in exchange for the transfer of their real property to the Operating Partnership.
Under the terms of the Operating Partnership, the property owner has the right to convert their OP Units into publicly traded REIT stock and would then be able to at a later date sell such publicly traded stock. Generally, under this UPREIT structure the property owner is able to convert one share of REIT stock in exchange for one OP Unit. At the time of the conversion of OP Units into the REIT stock the property owner would then recognize taxable income. The REIT may have the option to elect to pay cash to the OP Unit holder equal to the value of the REIT stock at the time that an OP Unit holder elects to convert their OP Units into REIT stock.
The result of the UPREIT structure is that the property owner is able to convert their illiquid real property into potentially liquid OP Units. The OP Units are liquid since they can be converted into publicly traded REIT shares that are traded on a national stock exchange. For property owners utilizing the UPREIT structure, it is important that they negotiate covenants to protect themselves from recognizing income due to the REIT having a future liability shift or the Operating Partnership selling the property which was previously contributed to the Operating Partnership.
© 2015, Law Offices of Robert A. Briskin, a Prof. Corp. All rights reserved.
Nothing in this article shall be deemed legal or tax advice as to any person or transaction. Please feel free to contact Robert A. Briskin if you have any questions.
1 The federal tax rates are now a maximum 20% for long-term capital gains, and 25% for recapture of prior real estate depreciation. California has no capital gains rate, so California tax rates on individuals apply (which maximize at 13.3%). Finally, the federal Medicare tax of 3.8% on net investment income may apply.
2 References in this article to partnerships also include limited liability companies. All Code references in this article shall mean the Internal Revenue Code of 1986, as amended.
3 For example, the President has proposed repealing Section 1031 tax-free exchange treatment for exchanges in excess of $1 million; and has proposed repealing the step-up in a property’s tax basis at death rule.
4 For example, the partnership should not enter into a real estate listing agreement nor sign the purchase and sales agreement (only the tenants-in-common should do so). Recently, the California State Board of Equalization in the published decision of Rago Development Corporation, 2015-SBE-001 (June 23, 2015) held that the taxpayer in fact did hold for investment the replacement property in a tax-free exchange, where the replacement property was contributed to a limited liability company seven months after its acquisition in a Section 1031 exchange. The length of time that tenants-in-common should own the relinquished property (after the partnership’s liquidation) in a drop and swap transaction before selling that relinquished property is subject to debate, but the conservative approach would be to hold the property as tenants-in-common for at least 12 months over two tax years.
5 There have been no private letter rulings or other guidance issued by the IRS in the Section 1031 tax-free exchange area for Section 708 partnership divisions.