While the 1031 exchange is one of the most popular mechanisms to defer tax on the sale of real estate, circumstances often arise where some partners in a venture would rather take their cash and move along. In these situations, I’m asked what mechanisms or structures can be utilized to facilitate a cash out of those partners, and what the corresponding tax results will be.
Three of the most common strategies for cashing out members include:
Cash redemption. This option often involves first selling the asset and then sending to the qualified intermediary (“QI”) only the amount of funds that the remaining partners intend to use in a 1031 exchange. Importantly, when this strategy is undertaken, the amount of cash that circumvents the QI is treated as boot, and each dollar is taxable gain. While the partnership may want to allocate 100% of this gain to only the redeemed members, and possibly even alter its partnership operating agreement accordingly, such allocations may lack substantial economic effect. As such, the departing partners are typically permitted to receive gain allocations so their ending capital account equals the cash received on redemption. Any remaining gain is allocated to the continuing partners – a negative result for those who were seeking tax/gain deferral via a 1031. Furthermore, while there is less cash in the QI from the sale, any amount of debt on the relinquished property must be fully replaced (not only the ratio of debt to continuing partners), or there could be mortgage boot gain.
Drop & Swap. This strategy involves changing the ownership structure of the asset so the redeemed members receive tenants in common (“TIC”) interests prior to any sale and cease to be members of the partnership. With this technique, the earlier this structure change occurs pre-sale, the better. Furthermore, it is recommended for the TIC owners to negotiate with the buyers directly. This strategy allows members to cash out in a transaction that circumvents the partnership entirely, so the tax results of any proceeds not involved in a 1031 remain only with those members.
Redemption for an installment note. This technique involves cooperation of the purchaser. In this strategy, the buyer provides some of the consideration via a Purchaser Installment Note (“PIN”), where proceeds are to be received in a subsequent tax year. This PIN exits (or never goes into) the QI and is distributed to the cashing out members in full redemption of their interest. Although the PIN would be treated as taxable boot, the gain is only recognized when the funds are received from the purchaser. Once again, the partnership is responsible to replace the full amount of any mortgage on the relinquished property, or risk gain from mortgage boot (which should be allocated to the departing members as well, thus accelerating some of their recognition). There are other complexities and nuances in this strategy that should be further discussed with your tax advisor.
Regardless of the strategy that is ultimately chosen, it’s best to take a proactive approach and begin the analysis when partners first indicate they may want to cash out rather than stay in the partnership following a 1031 exchange.
This article originally appeared in the 9/11 issue of Crain’s New York Business.