Partnership Exchanges: Structuring "Drop

and Swap" and "Mixing Bowl" Transactions Minimizing IRS Challenges and Maximizing Favorable Tax Treatment

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THURSDAY, AUGUST 21, 2014

Presenting a live 90-minute teleconference with interactive Q&A

Maher Haddad, Attorney, Baker & McKenzie, Chicago

Mark E. Wilensky, Counsel, Meltzer, Lippe, Goldstein & Breitstonen, LLP, Mineola, N.Y.

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Partnership Exchanges: Structuring "Drop and Swap" and “Mixing Bowl” Transactions

By: Mark E. Wilensky, Esq. Meltzer, Lippe, Goldstein & Breitstone, LLP

Mineola, New York mwilensky@meltzerlippe.com

516-747-0300 x284

&

Maher Haddad, Esq. Baker & McKenzie LLP

Chicago, IL Maher.Haddad@bakermckenzie.com

312-861-2666

© 2014 Meltzer, Lippe, Goldstein

& Breitstone, LLP.

All rights reserved.

Strafford Webinar

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Drop & Swap Example

• Partnership AB is looking to sell Blackacre

• Partner A wants to exchange for Whiteacre

• Partner B wants to exchange for Greenacre

• Partners no longer want to operate together in a partnership

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Drop & Swap vs.

Swap and Drop

Drop & Swap

• Partnership AB liquidates prior to sale

• Partnership conveys 1/2 undivided interest in Blackacre to each of A and B

• Tenancy in Common through date of sale

• Partners do their own exchanges for Whiteacre, Greenacre

Swap & Drop

• Partnership AB exchanges Blackacre for Whiteacre & Greenacre

• Partnership thereafter liquidates and conveys Whiteacre to Partner A, Greenacre to Partner B pursuant to plan of liquidation

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1031 Identification Requirements

• 3-property rule: identify no more than three properties, without regard to the fair market values of the properties

• 200-percent rule: identify any number of properties as long as the aggregate fair market value of all identified properties as of the end of the 45-day identification period does not exceed 200 percent of the sale price

• 95-percent rule: if identify more than three properties, and such properties have an aggregate value of more than 200% of the sale price, then must receive by the end of the 180-day exchange period identified property having a value of at least 95 percent of the value of all such identified properties.

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Holding Requirement for 1031 Exchanges

• Both relinquished and replacement properties must be held by the same person

• “Mixed person” transaction: one person transfers relinquished property, another person receives replacement property

• Court Holding

• Cumberland Public Service Co.

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Use Requirement for 1031 Exchanges

• Person must hold the property (relinquished and replacement property) for productive use in a trade or business or for investment

• Bolker

• Magneson

• FSA 199951004, re-released April 29, 2005

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1031 Not Applicable To Exchanges of Partnership Interests

• Distinguishing tenancy in common from partnership for tax purposes

• Co-ownerships vs. joint business enterprise

• 761 election out of Subchapter K

• IRS Revenue Procedure 2002-22

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Reporting Requirements

• Reporting distribution of TIC interests or distribution of property received in a like kind exchange on Form 1065

• Reporting ownership of tenant-in-common interests on individual 1040s

• IRS Form 8824

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The 11th Hour Drop & Swap

• Partnership AB is already in contract for the sale of Blackacre, or otherwise about to enter into contract

• Independent business purpose for the distribution of TIC interests?

• Chase

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Mixing Bowl Example

• A and B each own non-identical interests in a portfolio of 20 real estate LLCs

• Assume the aggregate FMV of all 20 properties is $100 million, and A’s aggregate interest is $40 million and B’s aggregate interest is $60 million

• Assume all 20 properties have built-in gain

• A and B want to separate their investments, with each owning 100% of some of the properties

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Mixing Bowl Example (con’t)

• A and B each contribute all of their interests in each real estate entity to “Holdings LLC”

• Holdings LLC, as a result, owns 100% of each of 20 real estate LLCs

• A receives a 40% interest in Holdings LLC, and B receives a 60% interest in Holdings LLC

• After, alternatively, two or seven years, Holdings LLC liquidates

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Mixing Bowl Example (con’t)

• Pursuant to the plan of liquidation, Holdings LLC revalues the real estate LLCs at $110 million and distributes all of its properties as follows:

• a 100% interest in 8 real estate LLCs to A having a value of $42 million plus $2 million cash

• A 100% interest in 12 real estate LLCs to B having a value of $68 million

• Cash, subject to true up

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Mixing Bowl Analysis

• For Federal tax purposes: Holdings LLC is treated as a continuation of the largest real estate LLC (by net asset value)

• The remaining 19 real estate LLCs are treated as terminating pursuant to an “assets-over” merger with and into Master LLC

• A and B treated as transferring undivided interests in built-in gain properties to Holdings LLC

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Mixing Bowl Analysis (con’t)

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• Anti-Mixing Bowl Provisions

• IRC 704(c)(1)(B)

• IRC 737

• Disguised Sale Rules

Anti-Mixing Bowl Rule #1: IRC 704(c)(1)(B)

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• Partner contributes property with built-in gain (or loss) to a partnership.

• Partnership distributes the property to another partner within seven years of the date of contribution.

• Contributing partner must recognize taxable gain (or loss) equal to the lesser of:

• the remaining built-in gain (or loss) inherent in the property at the time of distribution, or

• the taxable gain (or loss) that would be recognized if the property were sold for FMV immediately before the distribution.

• Potential recharacterization of gain as ordinary and loss disallowance under IRC 707(b).

Anti-Mixing Bowl Rule #2: IRC Section 737

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• Partner contributes property with built-in gain to a partnership.

• Partnership distributes other property (other than money) to the contributing partner within seven years of the date of contribution.

• Contributing partner must recognize taxable gain equal to the lesser of:

• the FMV of the distributed property less the partner’s outside basis immediately before the distribution (as adjusted) or

• the taxable gain that would have been recognized by the partner under IRC Section 704(c)(1)(B) if the contributed property had been distributed to another partner.

• Character of gain determined as if sold by partnership to third-party buyer.

IRC Sections 704(c)(1)(B) and 737 Can Apply

Simultaneously

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• Partner A contributes property A with built-in gain to a partnership.

• Partner B contributes property B with built-in gain to the same partnership at the same time.

• Partnership distributes property B to partner A in a non-liquidating distribution within seven years of the contributions.

• IRC Section 704(c)(1)(B) may cause partner B to recognize built-in gain with respect to the property B.

• IRC Section 737 may cause partner A to recognize built-in gain with respect to property A.

• Same result as if partners A and B had exchanged properties in taxable exchange in year of distribution.

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IRC Section 704(c)(2): “Like Kind” Exception

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• Partner A contributes property A with built-in gain to a partnership. Partners B contributes cash, which Partnership uses to purchase property X.

• Partnership distributes property A to partner B within seven years of the date of contribution.

• Partnership distributes property X to partner A within 180 days thereafter.

• Properties A and X are of “like kind.”

• Partner A’s gain under IRC 704(c)(1)(B) reduced by built-in gain of property X in the hands of partner A.

Exception from IRC Section 737 for Previously Contributed Property

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• IRC Section 737 does not apply to a distribution of property previously contributed to the partnership by the distributee partner.

IRC Section 707: “Disguised Sale”

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• Partner contributes property to a partnership and partnership distributes money or other property to the partner.

• Treated as a taxable sale of all or a portion of the contributed property by the partner to the partnership if--

• Transfer of money or other property to partner would not have occurred but for the contribution of property; and

• For non-simultaneous transfers, the subsequent transfer of money or other property to the partner is dependent on the entrepreneurial risks of partnership operations

• Presumption of “disguised sale” if transfers occur within a 2-year period.

• Presumption against “disguised sale” if transfers more than 2 years apart.

• Disclosure requirements.

Disguised Sale Regulations--Example

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• Partners I, J and K form partnership. I contributes unencumbered office building with FMV of $50 million. J and K each contribute $25 million of U.S. government securities.

• Income and cash flow from building is allocated 10% to I and 45% to each of J and K. Income and cash flow from U.S. government securities is allocated 90% to I and 5% to each of J and K.

• Partners “contemplated” that I’s interest in the partnership would be liquidated after two years from date of formation in exchange for government securities plus cash true up.

• Held: Disguised sale by partner I of office building to the partnership.

• Significant facts: office building unencumbered; substantially all rentable space leased on a long-term basis; not expected to need securities or cash flow therefrom to operate office building.