partnership exchanges: structuring drop and swap and...

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Partnership Exchanges: Structuring "Drop

and Swap" and "Mixing Bowl" Transactions Minimizing the Risk of an Unfavorable Audit Outcome

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

WEDNESDAY, AUGUST 30, 2017

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

Todd D. Keator, Partner, Thompson & Knight, Dallas

Crawford Moorefield, Partner, Strasburger & Price, Houston

Mark E. Wilensky, Partner, Meltzer Lippe Goldstein & Breitstone, Mineola, N.Y.

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Section 1031 Basics

• There must be an exchange

– Owner of Relinquished Property must never have actual or constructive receipt of sales proceeds

– Deferred or Reverse Like-Kind Exchanges are fine

• Reverse exchange where replacement property acquired before relinquished property sold – Rev. Proc 2000-37 safe harbors, 45 days to identify

relinquished property, 180 days to close sale

• Deferred Like-Kind Exchange – 45 days to identify potential replacement properties – up to

200% of FMV of relinquished property

– 180 days to close – on replacement property after sale of relinquished property

© 2017 Strasburger, LLP

All rights reserved. 4

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Section 1031 Basics (cont’d)

• Must be qualifying property – i.e., no stock, interests in trusts or partnership or LLC interests

• Replacement property must be of “like-kind” to relinquished property

• Both relinquished and replacement properties must be “held for productive use in a trade or business or for investment”

• Same taxpayer that starts the exchange must complete it

– Newly formed disregarded LLCs permitted to acquire title



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Bob wants to diversify his real estate holdings by contributing BobAcre to Swinger, L.P. The current

owners of Swinger, L.P. wouldn’t touch BobAcre with a 10-foot pole – think potential environmental liability. They would love to own Swing Acre, currently owned

by Mr. Mellow.

Swinger, L.P.

Bob

BobAcre

Carol Ted Alice

GrooveAcre

Swap and Drop Hypothetical



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Bob swaps BobAcre for Swing Acre. If Mr. Mellow preferred cash and another Buyer for BobAcre was out there, Bob could arrange a

deferred like-kind exchange through a Qualified Intermediary.

Bob Mr. Mellow

Swing Acre

Swap and Drop Hypothetical (cont’d)

BobAcre



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Immediately after the exchange, Bob contributes Swing Acre to Swinger, L.P. in

exchange for a 25% interest.

Swinger, L.P. Swinger, L.P.

Bob

Swing Acre

Carol Ted Alice

LP Interest

Swap and Drop Hypothetical (cont’d)



Magneson v. Commissioner, 753 F.2d 1490 (9th Cir. 1985), aff’g 81 T.C. 767 (1983)

• Taxpayers exchanged their fee interest in Property #1 with owner of Property #2 for 10% undivided interest in Property #2 (“Plaza Property”)

• On the same day, co-owners of Plaza Property contributed their respective undivided interests in Plaza Property to a newly formed limited partnership

• Taxpayers received general partnership interests in the new partnership

• Held: taxpayers held the replacement property for investment notwithstanding immediate IRC 721(a) contribution to partnership

© 2017 Meltzer, Lippe, Goldstein & Breitstone, LLP


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Drop & Swap Hypothetical

Carol Ted Alice Bob

Swinger, L.P.

Tedshire



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Swinger, L.P. distributes a 25% undivided interest in Tedshire to Bob in redemption of Bob’s

partnership interest.

Carol Ted Alice Bob

Swinger, L.P.

Drop & Swap Hypothetical (cont’d)


All rights reserved.

75% Undivided Interest in Tedshire

11

12

Swinger, L.P.

Bob

75% Undivided Interest

25% Undivided Interest

Tedshire




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Bob

Truth Acre 25% Tedshire

Mr. Murphy

Truth Acre

QI

Tedshire 25%

Mr. Mellow

$

$

Bob subsequently exchanges his 25% undivided interest in Tedshire for Truth Acre. Mr. Mellow

purchases the remaining 75% interest in Tedshire from Swinger, L.P.




The 11th Hour Drop & Swap

• What if Swinger, L.P. is already in contract for the sale of Tedshire, or otherwise about to enter into contract?

– Well documented independent business purpose for the distribution of TIC interests?

– Intention to rescind the transaction if sale falls through?

– Attention to details; books and records; follow partnership agreement; reflect drop on tax returns, etc. etc.



The 11th Hour Drop & Swap

• Independent business purpose for the distribution of TIC interests:

– Dissension

– “Fit and Focus”-type reasons to carry on business separately



Reporting Requirements

• Partnership reporting on Form 1065:

– Distribution of property received in a like kind exchange or contribution of such property to another entity (Question 13)

– Distribution of TIC interest in partnership property to a partner (Question 14)

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

• IRS Form 8824



Deemed “Mixed Person” Transactions

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

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

• Timing of intention to liquidate

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Court Holding v. Commissioner, 324 US

331 (1945) • Sale contract fully negotiated by corporation, but then tax advisors got in

the way.

• Corporation liquidated tax free and shareholders entered into identical sales contract.

• Court found under substance v. form doctrine that this was really a sale by the corporation.

– Unclear how far Court Holding goes but it appears to apply to the narrow band of transactions where the liquidation of a corporation was merely an afterthought and deal was already fully baked.

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Contrast US v. Cumberland Public Service Co.,

338 US 451 (1950) – Sale by shareholders to avoid corporate taxes condoned;

– Drop was considered while contract was being negotiated;

– Drop was implemented after contract was entered into by the corporation;

– Drop actually occurred 2 days prior to the closing;

– Purchaser – a power generation cooperative refused to purchase stock;

– Court seemed to focus on the fact that there was a “genuine liquidation” and that tax avoidance motivation was not impermissible.

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Chase v. Commissioner, 92 TC 874

(1989) • IRS successfully challenged last minute drop and swap

– Bad facts make bad law

• Partnership never liquidated

• Only the GP took a TIC; but stayed in the partnership

• Partnership agreement didn’t allow the distribution

• Partnership didn’t report the transaction as a drop of a TIC

• Books and records did not reflect the TIC

• Profits shared under partnership agreement even after the TIC was created.



Tenants in Common Must Avoid De Facto

Partnership

• Tenancy in Common

– May be treated as a partnership for tax purposes under Section 761

– Can destroy 1031 because partnership interests do not qualify

• Electing out of Subchapter K



Tenants in Common Must Avoid De Facto Partnership

• Activities must be limited to those customarily performed in connection with the maintenance and repair of rental real property

– Rents must qualify for UBIT exclusion

– Rev. Rul. 75-374: Third party manager not acting as agent of co-owners can provide non-customary services to tenants

– Property can be “wrapped” with a Net Lease

• Should observe formalities of separate ownership:

• Insurance

• Real estate taxes

• Notice to tenants

• May drop each TIC interest into separate LLC prior to distribution

• Better to hold for some period as TIC before exchange

23 © 2017 Meltzer, Lippe, Goldstein & Breitstone, LLP


Rev. Proc. 2002-22

• Ruling standards for:

– Multiple owners

– Single tenant under single lease

– Tenancies in common interests are packaged and marketed for smaller 1031 exchanges

– Also useful for portfolio transactions where one property is used as replacement property for multiple entities



Key Requirements under Rev. Proc. 2002-22

• Not more than 35 owners

• Related parties as defined under sections 267(b) and 707(b) interests are aggregated for purposes of the 35 owner rule

• Partnership returns not filed

• Limited co-ownership agreement permitted

• Right of first offer to other co-owners, call options allowed

– Put rights generally not allowed

• Majority voting on certain matters

• Unanimous approval required for sales, leases, financings, hiring managers, etc.



Key Requirements under Rev. Proc. 2002-22

• Each co-owner must be permitted to sell or encumber without approval of other owners

• Certain “common” lender restrictions are allowed

• No business activities allowed

• Activities limited to customary maintenance and repair of realty

• Must not conduct business under a common name

• Management agreements must be renewable no less frequently than annually



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Could you achieve the same tax result by having Swinger, L.P. sell a 75% interest in Tedshire to Mellow for cash and swap the other 25% for Truth Acre and

simply allocate all of the taxable gain to Carol, Ted and

Alice? Substantiality issue under IRC 704(b).

Carol Ted Alice Bob

Swinger, L.P.

Alternatives to Drop & Swap: Special Allocations

Tedshire



Other Alternatives to Drop & Swap—Single Relinquished Property

• Partner buyout or redemption prior to sale

• Requires partners/partnership to have cash

• Buyer installment note requiring at least one payment the following year

• Qualified intermediary installment note requiring at least one payment the following year

• May mean high debt-equity ratio for replacement property, if relinquished property was encumbered



Other Alternatives to Drop & Swap—Single Relinquished Property

• Tracking Units

• Different partners designate their own replacement property

• Partnership acquires multiple replacement properties

• Partnership agreement provides for tracking allocations of profit and loss



With Multiple Partnerships – Drop and Swap can be used to divide up

portfolio

• Tenancies in common can be mutually exchanged



Drop & Swap—Multiple Properties

• Properties held in a large number of brother/sister partnerships

• How much does ownership overlap?

• What percentage is owned by outside investors?



Drop & Swap—Multiple Properties

• Practical difficulties of structuring many drop & swap structures

– Are the parties really willing to become tenants in common?

– Carried interests?

– Control?

– Imminent sale?

• Practical difficulties of structuring mixing bowl

– Multiple entities with different partners can be difficult to combine fairly

– Long waiting periods together may not be acceptable © 2017 Meltzer, Lippe, Goldstein & Breitstone, LLP


The Mixing Bowl Alternative

To Swap Involving Multiple Properties



Mixing Bowl Examples

• The Question: How soon can the partners dissolve the mixing bowl partnership?

• Parties agree to liquidate after, alternatively:

– Less than 2 years

– More than 2 but within 7 years

– More than 7 years

• Can agreement contain liquidation procedures to avoid contention later as to who gets which property interests (e.g., auction)?

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The Mixing Bowl Alternative:

2-Person Partnerships

• A and B own all of Company 1 and Company 2

• Company 1 owns Property 1

• Company 2 owns Property 2

• A and B want to go their separate ways

– Partner A wants Property 1

– Partner B wants Property 2

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THE “DISGUISED SALE” RULES

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IRC Section 707(a)(2)(B): “Disguised Sale”

If: (i) there is a direct or indirect transfer of money or other property by a partner to a partnership,

• (ii) there is a related direct or indirect transfer of money or other property by the partnership to such partner (or another partner), and

• (iii) the transfers described in clauses (i) and (ii), when viewed together, are properly characterized as a sale or exchange of property,

• Then: such transfers shall be treated either as a transaction occurring between the partnership and one who is not a partner or as a transaction between 2 or more partners acting other than in their capacity as members of the partnership.

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IRC Section 707(a)(2)(B): “Disguised Sale”

• Reg. sec. 1.707-3(b)(2) lists factors tending to indicate disguised sale:

• Timing and amount of subsequent transfer are determinable with reasonable certainty.

• The transferor has a legally enforceable right to subsequent transfer.

• Arrangements are in place to ensure that the purchase price can and will be paid (e.g., financing commitments and commitments to contribute by others, marketable securities in partnership).

• Bottom line: is the subsequent transfer of property to the contributing partner subject to entrepreneurial risk of partnership operations?

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THE ANTI-MIXING BOWL RULES

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Anti-Mixing Bowl Rule #1: IRC

704(c)(1)(B)

• If: any property contributed by a partner is distributed (directly or indirectly) by the partnership (other than to the contributing partner) within 7 years of being contributed—

• Then: the contributing partner shall be treated as recognizing gain or loss (as the case may be) from the sale of such property in an amount equal to the gain or loss which would have been allocated to such partner under IRC 704(c)(1)((A) by reason of the variation between the basis of such property to the partnership and its FMV at the time of contribution if the property had been sold at its fair market value at the time of the distribution.

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Anti-Mixing Bowl Rule #1: IRC

704(c)(1)(B)

• If: any property contributed by a partner is distributed (directly or indirectly) by the partnership (other than to the contributing partner) within 7 years of being contributed—

• Then: the contributing partner shall be treated as recognizing gain or loss (as the case may be) from the sale of such property in an amount equal to the gain or loss which would have been allocated to such partner under IRC 704(c)(1)((A) by reason of the variation between the basis of such property to the partnership and its FMV at the time of contribution if the property had been sold at its fair market value at the time of the distribution.

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Anti-Mixing Bowl Rule #2: IRC Section

737

• In the case of any distribution by a partnership to a partner, such partner shall be treated as recognizing gain in an amount equal to the lesser of—

• (1) the excess (if any) of (A) the fair market value of property (other than money) received in the distribution over (B) the adjusted basis of such partner's interest in the partnership immediately before the distribution reduced (but not below zero) by the amount of money received in the distribution, or

• (2) the net precontribution gain of the partner.

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Substantially Identical Interest

Exception

• No new section 704(c) layer created, so anti-mixing bowl rules do not apply (unless otherwise dealing with 704(c) property)

• Proposed Regulation sections 1.704-4(c)(4)(ii)(E) and 1.737-2(b)(1)(ii)(E) (97 percent de minimis exception):

• Notice 2005-15 (same owner same proportion exception)

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IRC Section 704(c)(2): “Like Kind”

Exception • Special rule for distributions where gain or loss would not be recognized outside

partnerships.—Under regulations prescribed by the Secretary, if—

• (A) property contributed by a partner (hereinafter referred to as the “contributing partner”) is distributed by the partnership to another partner, and

• (B) other property of a like kind (within the meaning of section 1031) is distributed by the partnership to the contributing partner not later than the earlier of—

– (i) the 180th day after the date of the distribution described in subparagraph (A), or

– (ii) the due date (determined with regard to extensions) for the contributing partner's return of the tax imposed by this chapter for the taxable year in which the distribution described in subparagraph (A) occurs,

• then to the extent of the value of the property described in (B), IRC section 704(c)(1)(B) shall be applied as if the contributing partner had contributed to the partnership the property described in (B).

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IRC Section 704(c)(2): “Like Kind”

Exception

• Treasury Regulation section 1.704-4(d)(3)

• “the amount of gain or loss, if any, that the contributing partner would otherwise have recognized under section 704(c)(1)(B) and this section is reduced by the amount of built-in gain or loss in the distributed like-kind property in the hands of the contributing partner immediately after the distribution. The contributing partner's basis in the distributed like-kind property is determined as if the like-kind property were distributed in an unrelated distribution prior to the distribution of any other property distributed as part of the same distribution.”

• Disguised sale rules may still apply.



IRC Section 737 and the “Like Kind”

Exception

• Reg. sec. 1.737-1(c)(2)(iv): “Net precontribution gain” is determined after taking into account--

• Any gain or loss recognized by the partner under section 704(c)(1)(B) and regulation section 1.704-4 on an “actual distribution” to another partner of property contributed by the distributee partner that is part of the same distribution to the distributee partner; and

• Any gain or loss that “would have been recognized by the partner except for the like kind exception in section 704(c)(2) and regulation section 1.704-4(d)(3).”



IRC Section 737 and the “Like Kind”

Exception

• Reg. sec. 1.737-1(c)(2)(v):

• “A distributee partner’s net precontribution gain is determined without regard to the provisions of section 704(c)(2) and section 1.704-4(d)(3) in situations in which the property contributed by the distributee partner is not actually distributed to another partner in a distribution related to the section 737 distribution.”

• Preamble to Regulations:

• “This provision clarifies that section 737 does not contain a like-kind exception similar to the exception in section 704(c)(2). Section 737 applies even if the property received by the partner is of a like-kind with the contributed property.”

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Thank You

Todd D. Keator

Thompson & Knight LLP, Dallas, TX

[email protected]

Crawford Moorefield

Strasburger, LLP, Houston, TX

[email protected]

Mark E. Wilensky

Meltzer, Lippe, Goldstein & Breitstone, LLP, Mineola, NY

[email protected]

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