Navigating Tax Opportunities in 1031 Exchanges | Part III

Astrid Garcia: Polling Question #2.

Michael Torhan: While everybody works on that polling question. Again, what we won't cover on today's session is some of the basic 1031 concepts such as the timing considerations, the identification considerations. Some of those were covered on our prior sessions again, but all important pieces of a 1031 exchange is understanding when do you have to identify new property? When do you have to complete the exchange buy? We're really going to be focusing on some of the math behind 1031 today again, as well as some of those situations that are unique but not so unique when you're dealing with partnerships.

Astrid Garcia: Great. So I will be closing the polling question now. Please make sure you submitted your answer. Back to you.

Michael Torhan: Great, thank you Astrid. So it does look like many of you are about half attended it. About 80% attended at least one of the last few sessions. Great. So just starting off with a quick 1031 refresher. Again, the basic result everybody always tries to achieve in a 1031 exchange is you want it to be a non-recognitioned transaction. The goal is to have no gain recognized on the sale of old property. Obviously I roll here, no gain or loss. Clearly, if you have a loss on the sale of property, a 1031 is most likely not ideal, right? You'd want to recognize that loss to offset potential other income. So a 1031 exchange, you are trying to achieve non-recognition of any gains. Again, many of... I've heard that if you have boot, if you receive boot and we'll get into what's boot a little later, if you do receive boot, there is some recognition on the exchange. Note that technically you are realizing gain or loss, the sales price of your property unless you adjust the tax basis that is realized basis.

If you just took all the cash out, you would have some economic profit, but in a 1031 exchange, you're trying to defer recognition of that gain. So that's just a difference between what's realized versus what's recognized for tax purposes. We have a comment here that again, technically you may have gained that's recognized for 704(b) purposes. I've seen this in practice before where there's a revaluation event, right? So in conjunction with a 1031 transaction, you also have let's say a new partner coming in with some cash. Well, that's what we call a revaluation event. So for your book capital accounts, your economic capital accounts into partnership, you may be booking up all the existing partners. For example, if there was a partner that had a profit interest, some promote in the original structure, you may be recognizing the gain again, only for book purposes, not for tax purposes. Again, the main goal here being is we're trying to defer recognition for tax purposes of any gain. And again, another key point is in a successful 1031 exchange, you will have carryover tax based on the property. Again, we'll go through a couple examples.

Here's a very basic example of a 1031 exchange. Again, I'm not going to spend too much time with this. I'm just setting the foundation for more advanced examples. Again, here we were just showing the sale of a property for a million dollars with a sum of 150,000, which leaves 250,000 bucks of cash and you're purchasing a replacement property for the exact same value, same exact debt. Again, clearly this is an unlikely exchange, right? In most exchanges, there's usually a difference in fair value, a difference in debt, but this is just a very basic example. If you look at the closing statement, $250,000 of cash from the sale is pushed into the QI, which is the co-fund intermediary, and then that 250,000 is used to close on the purchase of the new property. Again, the same debt applies to the new property because you need to come up with a million dollars of cash.

Again, looking at realized gain, if we assume 800,000 of tax bases, we have 200,000 of realized gain, the million dollars less your tax bases. Clearly this should be a successful 1031 assuming all the other requirements are met, we have no recognized gain. The deferred gain is the realized gain less the recognized gain, right? So 200,000 was realized. Nothing is recognized. We have 200,000 of deferred gain. Your basis in the new property is a carrier basis. Usually the easiest way to think of this is what's the fair market value of your new property, the million dollars less your deferred gain of 200,000, which results in 800,000 of basis in the new property. Again, why does that make sense? If you sold the replacement property the very next day, you would have 200,000 of gain, which is your deferred gain.

So let's change the facts a little bit. Now, let's say we actually buy a property that's worth more. So we buy our property for $1.25 million. Clearly here we need to take on more debt. You could also put in more cash here, which we'll talk about a little bit later. But in this example, we take on more debt of 250,000. So we see that here we have more debt on the purchase and that additional debt results in additional basis. So in the analysis down below, it's the same realized gain. We had a million dollars of property that we sold less than our adjusted tax basis, which results in 200,000 realized gain. Your recognized gain is zero. We replaced all the cash in the debt into the new property, which means your deferred gain is the 200,000 that you realized because we're not recognizing any of that.

And then so what is our new basis in the new property? So here's where the outcome changes. So if we take the new fair market value, which is 1.25 million and you subtract out the deferred gain of 200,000, like I mentioned, that's the easiest way to solve for the new basis. The difference is 1,050,000. So another way to think about that is if you took the 800,000 of carryover basis, the 800,000 was our basis in the old property. Again, like we mentioned earlier, your existing basis generally carries over into the new property. Plus we took on $250,000 of new debt. You could see that above we had 750,000 of debt that was essentially replaced to a million dollars of debt. That additional $250,000 of debt gives us new basis in the property. And this is going to be important when we talk about depreciation in a little bit.

So what is boot? So in these first two examples, we have not had boot yet. The cash that we got out of the exchange went into the new property. We completely replaced the existing debt on the existing property right with the new property. What happens with boot and what does boot mean? Again, like I mentioned earlier, non-recognition treatment applies when you exchange old property, which is commonly called relinquished property exclusively for like-kind new property, which is also called replacement property. Well, what happens when you don't get like-kind new property or if you get some cash out of the deal or if you don't completely replace your liabilities. Let's say the old property was worth a million and your new property is only worth 900,000. Well, in any of those cases you're now receiving what's called a boot. Boot is the receipt of other property. And what are some examples?

Cash is the easiest example. If you put cash out of a deal, that's other property, cash is not like-kind to real property and therefore that cash is treated as boot. Likewise, if you have non like-kind property. So this was a change that occurred a couple of years ago for a tentative exchange to be valid like-kind property has to be real property, so you have to sell real property and you have to acquire real property. You can no longer acquire or exchange non real property. That was allowed a number of years ago, but under the rules that changed, real property is the only type of like-kind property now.

And the last type of boot I mentioned here is relief of liabilities. You'll see this a little bit, but when you're selling property and there's debt on the property, the relief of that debt, when someone pays you a million dollars for the property, you're using that million dollars to pay off the debt. That relief is actually boot. Again, which can be mitigated if you acquire new property with either one, the same amount of debt or two, with cash. And we'll have some examples that go through that as well.

David Shechtman: Michael, I think worth noting here is the liability netting rules are a little bit tricky. There is a notion that says, "Well, it has to be an assumed liability," and in most cases, I'm selling my relinquished property, the buyer is not assuming my liability. The buyer might love to assume my old 2.5% mortgage, but that's not going to happen. So it's paid off at closing, but there is favorable authority that says, "Look, if the closing agent, the title company just sends the money to pay off the liability, it's as if the buyer first assume that liability and then immediately paid it off." So I'm not dealing with cash boot, which is much more difficult if not impossible to offset. I'm dealing with liability relief boot, which as you'll get into can be offset. The other thing worth noting and then again, good point emphasizing the 2017 change that said, "Real property only."

Often when we sell real estate, if it's a hotel or an apartment building, there is incidental personal property that's included in the sale, that cannot be exchanged. So you need to be careful. You might get a buyer who's saying, "Let's allocate a lot to personal property because I can write it off more rapidly or because where we reduce our realty transfer tax if we're in a state like New York or Pennsylvania with a high realty transfer tax," but that's going to come back to bite the seller because you cannot defer the gain on personal property or intangibles.

Michael Torhan: Great, thank you. Great points David. Thank you. And we'll talk a little bit more about that netting principle actually in the subsequent two slides as well. David raises a great point and then we'll touch briefly on the non like-kind assets as well because yes, David, I completely agree. I've seen it in practice where there's usually competing interest right between the buyer and the seller in terms of allocations both for income tax purposes and for transfer tax purposes. So great points. Thank you. Again, building on the same examples we've had up until this point, here's the same example, except rather than purchasing a new property for a million dollars, we only buy something for 900,000. Well, you might ask, "Well, where's the other 100,000?" The $100,000 is coming back to us into our pocket, so we're still taking on the same debt and the new assets of 750, but clearly out of the 250,000 of cash proceeds we're now pocketing $100,000.

That $100,000 that's coming out of the exchange, that's boot, right? That's non-like kind property and that's going to trigger gain to us. So the entire analysis is the same but down below you now see on the right side first boot received, you have a $100,000 here that's received in the cash column, right? And that $100,000 is recognized gain, which means that our deferred gain is now only a $100,000. Our carrier basis is still 800,000. Why is that? Well, the fair market value of the new property is 900,000. The deferred gain is a 100,000. Again, which leaves our deferred... Our basis to be $800,000. So this slide goes into more detail as to David's comments on the debt relief and the debt on the old property and the new property. The literal reading of the rules is yes, that it's an assumption of liabilities or a transfer subject to a liability is treated as other property or money unless it's that corresponding assumption.

Like David mentioned, I originally had this whole slide with the sites from that court case, from that guidance out there. I got rid of that. Again, the takeaway is that your proceeds from the sale of your relinquished property, the property you're selling can be used to pay off the debt on the old property if you then incur debt on the purchase of the new property that equals or exceeds the debt on the old property. Again, so here the guidance saying you're able to get away from this boot if you replace the debt or if you're able to absorb the debt relief. And as we'll talk about on in a slide or two, it's not just with new debt. You could actually put in new cash on the replacement property and that's what's called the boot netting principle.

David Shechtman: Yeah, one quick point that's an important one I encounter a fair amount. There's nothing in the regulations that says the debt has to be secured by a mortgage or a deed of trust. The principle for boot netting is, is the debt required to be paid off upon the sale of the property? So you might have a situation with three partners, one of them lent money to the partnership and is both a partner and a creditor, and let's assume it's formalized with a note and the note says once the property sells, my debt gets repaid. That is liability relief boot and can be offset as Michael discussed, even though it's not secure. Now, I can't say I'd like to use that cash to pay off my credit card debt because that's unrelated debt, but any debt that you can source to either acquiring the property or improving the property or that needs to be repaid when the sale takes place is going to be treated as good debt for this purpose and can be paid off at closing.

Michael Torhan: Great. And to that point, right, this slide effectively summarizes most of what we've been talking about. Again, key takeaway being the mortgage on the old property can be offset either by mortgage on new property or a cash infusion into the exchange. So you may take out less debt on the new property. Let's take an example, in the current economic environment, if you're selling a property and then you want to buy a replacement property with the same exact fair value, but let's say that the banks don't want to underwrite that loan to value, an alternative is you could infuse more cash into the exchange to acquire the replacement property. So effectively your mortgage boot, the boot that you're recognizing so to speak or decline in mortgage can be offset by cash that you put in. But as we'll talk about the opposite, it does not hold true. You can't offset cash boot with additional debt.

What's the general rule of thumb for a good exchange? Is the purchase price of the new property equal to or greater than the sale price of the old property? If you sell something for a million dollars, you want to make sure you're buying something new for a million dollars or more. Again, assuming all other factors work. If you're selling something for a million dollars and you're only buying something for 800,000, well that either means you're pulling out cash from the deal or you have some kind of excess mortgage boot. So here's an example where... Again, same example as earlier, same facts except now the debt we're taking on the new property is only 650,000, while the other 100,000 has to come from somewhere and here we're putting in a 100,000 of new cash. That cash that we're putting in, as you see here it's boot paid that offsets the debt a $100,000. That's a positive there.

So in this example, we're still ending up with a result that is favorable to us. We've effectively replaced a $100,000 of debt with a $100,000 of cash from the outside. Now contrast this to a situation where we increased the debt, we increased the fair market value. So at first glance, this seems like this works, but when you get into the details you see that we're actually pulling out a $100,000 of cash from the transaction, right? We had $250,000 of cash proceeds, but we've elected to take that $100,000 out and in turn we increase the debt up to 1.1 million, right? We still need to come up with the complete proceeds for the purchase. That additional debt does not offset the cash that comes out to us. So that 100,000 that comes out to us does get recognized as gain in this exchange.

David Shechtman: And again, even here, even though I've traded up in value, I've traded down in equity-

Michael Torhan: Great point, yes.

David Shechtman: ...and therefore I've patched out some of my investment and therefore I have boot. My equity in real estate has been reduced. So good shorthand trade equal or up in both equity and value. No boot trade down in either you have boot. Not worth going into now, but often comes up and you'll see a lender who isn't just making an acquisition loan but also wants reserves set up and you have difficult questions. Are the exchange funds going to pay for reserves, which is not good replacement property or is the excess loan amount going to the reserve? So those are some of the more advanced questions you might see on debt netting.

Michael Torhan: Some other rules relating to boot, if you recognize boot generally the way I like to look at it is the worst income is recognized first. For example, unrecapture 1250 gain is generally recognized first as boot triggers gain recognition in exchange. Once the cash is pulled out of the exchange. I've gotten this question in the past or whether the closing was done or some cash was taken out of the exchange, it wasn't put into the QI, could they put that money back into the QI? The general rule is no, you can't undo boot. David, I don't know if you've seen any unique circumstances with this, but that's really what we've seen.

David Shechtman: The phrase you often hear in 1031 world is you can have constructive receipt of the sale proceeds. Worse than constructive receipt is actual receipt. So once you receive the cash, it's hard to undo that unless the title company made a clear error or something like that and you immediately wire the funds back the next day. I've seen that and there's actually a case that says you're not going to punish the taxpayer for a title company footfall, but otherwise, once you receive that cash boot it's actual receipt and taxable. And as Michael said, the bad income, the 25% on un-recaptured 1250 gain, or if you have 1245 property with 1245 recapture an ordinary income, the bad stuff comes out first.

Michael Torhan: Great. And just so as we talk about boot, boot is dollar-for-dollar gain recognition. Easy example here, if you have $200 of sales proceeds $50 of adjusted tax basis, your realized gain is $150. And now let's assume we have $25 of boot. Your recognized gain is not some kind of pro rata. You don't get to absorb basis against that gain. For example, it's not 25 over 200 times the 150 of gain. The $25 of boot is $25 of gain. So the boot does carry with it income equal to the boot. Boot does not necessarily cause a 1031 exchange to fail. At a certain point though, if you have too much boot, a 1031 may not make sense if you're recognizing most of the gain anyways.

David Shechtman: Yeah, I think a good way to think about this is until you expend more on replacement property, then your basis in the relinquished property, you haven't deferred any gain and you've accomplished nothing. So if you've got basis of 500 in a sale for a thousand, don't think you're going to get any benefit by buying 500 of replacement property because all the 500 boot gets recognized.

Astrid Garcia: Polling Question #3.

Michael Torhan: This is going to be a good segue into depreciation matters and cost segregation effects on a tentative exchange. Now that we've talked about is there a recognized gain or is there deferred gain as well as what is your basis on the other side of the exchange? The logical next question is, well, what happens to depreciation both during the exchange? From the other sessions you may recall that there's usually a time period between when you sell the original property, when you buy the new property. So what's happening in that intermediate period as well as what happens with the new replacement property? So we'll go through some of those considerations now.

Astrid Garcia: Awesome, so I will be closing the polling question now. Please make sure you've submitted your answer. Back to you.

Michael Torhan: Thank you. So this timeline represents how depreciation applies in a tentative exchange. With the relinquished property, you have depreciation that continues until the day of sale. Just like any other property that you sell, you're allowed to take depreciation until that point. In the intermediate period between the sale of that property and the purchase of the replacement property, there's no depreciation. And keep in mind this can cross over years. Many times a property will be sold before year-end and your replacement property won't be purchased until the following tax year. What this means is that you have a period of time where there's no depreciation that you benefit from. When the new property is acquired, depreciation again once again begins on the date of the new purchase and so the next query is well, how does that depreciation work? What recovery period applies and what allowances are allowed for that replacement property?

The next couple of slides are going to go through some of those rules. There's a couple of questions. Number one is what's the recovery period of existing property, a new property? Is a new property depreciable or non-depreciable and likewise is any bonus depreciation allowed? So that will be covered over the next couple of slides. If the recovery period of your replacement property, the new property is the same or shorter of the original property, you follow the same recovery period as your relinquished property. Right?

So even if you're acquiring replacement property, for example, if you're going from commercial which is 39 down to a replacement property, which is residential 27 and a half, you continue depreciating the carryover basis using the longer 39 years. If you're buying property that has a longer recovery period, unfortunately you have to then use the longer period on the new property. Again, if you're selling residential property that has 27 and a half years and you're purchasing commercial property which has a 39 recovery period, you now have to depreciate that carryover basis as if you were always on a 39 period. So effectively you're prolonging the depreciation recovery timeline on that carryover basis.

And here it's important to differentiate between what's old basis versus new basis, right? So old basis is effectively your carryover basis. It's the basis that you're carrying over from the old property. As we talked about, you may have new basis in exchange. And where does that new basis come from? It could come from generally one of two places. Either one, you have new cash that comes into the exchange. If you're trading up in value, you have to put in additional cash to buy the new property or you're taking on new debt for the new property. So that additional cash or that new debt generates new basis or what the regulations call excess basis.

It's any excess in basis on the new property over the old exchange property. The excess basis is treated as placed in service in the year of replacement. So it's treated as new property that's acquired in the year that you buy the replacement property and you effectively have to look at all of the applicable depreciation attributes of that new property. So the recovery period, the method as well as the convention. And here I highlight this. This may include bonus depreciation. So here is where a cost seg really provides some value is that if you're able to allocate some of the additional basis to lower class lives, that may produce a bonus depreciation. Sometimes a question-

David Shechtman: [inaudible 00:35:08] I apologize. One important point here is you don't get to pick and choose how you allocate your excess basis. You can't say I've got 5 million excess basis and did the cost seg study and we've got 5 million of cost seg property, HBACs [inaudible 00:35:32], whatever. You can't say, "Okay, all [inaudible 00:35:35] million goes to the cost seg property, and I can take on this on." In the year of the replacement, the rules say allocate excess basis [inaudible 00:35:47] everything you require. So it may be at the end of the day you've got 5 million of excess basis but only 1 million of cost seg property that you can take on this.

Michael Torhan: Correct. Great point, David. You really have to look at what is the true amount of in the excess basis rate that can be allocable to potentially a cost seg, which is eligible for bonus depreciation. This slide compares what happens if you trade between depreciable and non-depreciable assets. If you sell depreciable property and you acquire land or non-depreciable property, you cannot depreciate the replacement property. On the flip side, if you go from non-depreciable property to depreciable property, you do get to treat the new property as depreciable property. Likewise, if you're going into a mix of non-depreciable and depreciable property, you need to allocate the basis between non-depreciable and depreciable assets.

Again, just as a follow-up on what we've been discussing on cost segs, where our cost segregation may apply, David and I were saying there may be an allocation of that new excess basis which may assist in getting some bonus depreciation. Bonus depreciation over the last several years was at a hundred and actually went down to 80% in 23, and as many of you may be aware, it's currently being phased out. So bonus depreciation is 60% in 24 and it's going to continue to phase out over the next several years. There is some legislation out there to reinstate a hundred percent bonus depreciation. That has not been passed yet, so stay tuned for that.

Bonus depreciation may go back to a hundred percent again, but that legislation is not final yet. I think the bottom line here is that if you are trading up in fair value on a 1031 exchange, it may be worthwhile consulting with a cost segregation team to see if there's any benefits from bonus depreciation on the new basis. I know we here, we handle cost seg studies for a lot of clients. We have an in-house team that will prepared this reports and many times when we work on 1031 exchanges with our tax clients, they are trading up in value and so we'll generally get the cost seg team connected with the taxpayer and then we'll make sure to identify if there's any potential benefits from a cost seg study.

A couple of other advanced concepts before we talk about partnership interest, I talk about partnerships at the bottom of this slide, we're going to talk about the whole partnership context surrounding tentative exchanges over the next 10 or so slides. But I did want to bring up a couple of other items. Sometimes a tentative exchange will fail, right? Sometimes a seller will have good intent to complete a tentative exchange, but for one reason or another, either they won't be able to locate replacement property or they won't be able to close on a replacement property and at the end of the day they'll just take the cash-out from the QI and just agree to recognize the income. If the sale of the original sale and then the ultimate collapse of the exchange crosses over a tax year. There may be an opportunity for an installment sale treatment to apply there. If you think about that cash, if the cash is really locked up with the QI, you don't have receipt of that cash right until the subsequent year.

There oftentimes is a way to treat some of that gain under the installment sale rules. Again, a key consideration here is that mortgage relief in year one maybe be treated as a receipt of cash in that year one under the installment rules again, so it may not be complete deferral into that second year of the gain. Like we mentioned earlier, real property is the only type of like-kind property. So a question often comes up, well, what if the old property had a cost seg done on it and that cost seg had allocated some of the basis down to 15-year property or five-year property. Do you still have real property or do you not have real property?

The guidance out there, there were proposed regulations on these rules and there were some final regulations. The bottom line there is it's not so clear, but the bottom line is that just because you treat something as five-year property or 15-year property doesn't mean that it's not real property for a 1031 exchange. So there's certainly some analysis that needs to be done there to make sure that all of those original assets are real property because if you do have five-year property that isn't real property, well that may not be eligible for the 1031 exchange. So certainly it's not a fatal error just because you did a cost seg on the old property or that you're doing a cost seg on the new property, but it deserves a second look to make sure, well, was it really all real property? And that's effectively what the regulations provide for, is that for 1031 purposes it has to be real property again, which may not be necessarily the same as your depreciation fixed asset schedule.

We really didn't talk about exchange expenses too much, but clearly during an exchange you'll incur various types of exchanges both on the selling side and on the acquiring side. You'll incur commissions and legal fees, accounting fees. Generally those are good expenses and so they get factored into the exchange computation if they don't throw a boot, right? We're always trying to avoid boot being thrown off out of the exchange. The issue arises when you have prorations, so things like security deposits and real estate taxes and other types of prorations between buyer and seller. There are instances where we're using the proceeds within the exchange for those prorations may throw off boot. So always keep in mind that just because you're not getting the cash in your bank account doesn't mean that you may not have a risk for having boot in the exchange.

And then the next two points are really a great segue into the second part of this session, the 1031 rules provide that the selling taxpayer for the relinquished property, the original property that's being sold, that taxpayer needs to be the same taxpayer that's acquiring the replacement property, the new property. Things like disregarded entities. So single member LLC. Oftentimes for legal purposes, you may have a special purpose entity that's set up for legal purposes. Those are disregarded. So as long as that regarded owner is the same taxpayer on both sides, that's okay, but you can have... It can't be David and I in a partnership that we sell a property and then I go and I buy a replacement property. Without the proper planning and structuring and some of the things we're going to talk about, it has to be the same taxpayer, right? If David and I are in a partnership, the general rule is that partnership needs to sell the old property and buy the new property.

Again, that's just a general rule. We'll talk about some situations over the next couple of slides. So what happens though in real life, right? Real estate is commonly owned by partnerships and therefore sales happen all the time in the partnership setting, but sometimes the partners may not want to continue with that partnership. Some partners may want to cash out and not continue with any new acquisition. They may just want their pro rata share of that original property that's being sold and they just want to take the cash and separate from the venture. Some partners may want to continue with the exchange or with a exchange.

They don't want to pick up the income, they want to continue to defer with a replacement property, but they don't want to do it with the same partners. Our third scenario is, well, some partners may want to do a temporary exchange, but they have their own properties that they want to choose. So there's two different partners. They each have their own property that they want to acquire. So what do we do? What kind of planning and structuring is allowed here and what are some of the ideas? And with that, I'll pass it off to David who will share some of his experience.

David Shechtman: And only because I can't resist, I'm going to raise two more points on depreciation which often come up just so everybody has a good background on that. We talked about the 1245 property. Please keep in mind that if you are selling 1245 property and don't buy the same amount of 1245 as replacement property, you have recapture. So that's the one situation where you can trade equal or up in value and equity, but you still have income because you have depreciation, recapture trumping, 1031, unless having done a cost seg on the relinquished property, you also do a cost seg on your replacement property and you have the same amount of 1245 property on each end. The other thing, and I often see this with my clients is, okay, I'm selling for a million. I'm buying for 800,000. I looked at Michael's slides, I know I'm going to have 200 in gain, but there's about 200 of renovations I want to do to my replacement property.

Is there any way I could pick those up? And the answer is yes, it's more complicated to do a construction exchange, but often it's not the best advice to do that because if you can take that 200 and use it for improvements that are five-year or 15-year land improvements, or even 179 type property, you're going to get an ordinary deduction for that as opposed to a reduction in your capital exchange. So maybe better served by just recognizing some boot and then getting large bonus depreciation deduction. So onto partnerships, and we're going to start with the example and we've got three equal partners in a partnership that owns the relinquished property. It's already entered into a purchase and sale agreement with the buyer. I always joke that in my legal career I've worked for firms that small as 75 lawyers, as large as 1400 lawyers. Any of those firms would have half as many lawyers if partners in partnerships, particularly family partnerships, all got along and were of the same mind.

They rarely are. So a quick mention of two techniques that I don't discuss, you might say, well, why don't the partnership just distribute tenants in common interest to partners one, two and three in this slide? And the answer is maybe that works if you haven't already entered into a purchase and sale agreement. And if the partners are willing to hold his tenants in common, which is a different arrangement and different legal limitations than a partnership, you can't have centralized control. Maybe that's considering as working, but here we're assuming the client comes to us and they've already agreed to sell and now the partners have differing views. Another thought or technique that's sometimes mentioned is partner one wants to sell or cash out, can we just do an exchange with boot and especially allocate all the gain to him so that the other partners don't have to recognize any boot gain?

To me, I've never been persuaded that that has substantial economic effect and therefore I shy away of that technique. Even the people who think it worked we'll tell you if you have a positive capital account, there's only so much gain you can allocate to the cash-out part. So here we're assuming we've got a partner, one who wants to receive cash, the other two want to go ahead and do an exchange. How can we handle that? The one technique that I use a lot is the so-called qualified intermediary note because remember the qualified intermediary is deemed to be the buyer of this property for tax purposes and then turns around and sells it to the real buyer. Here we would say to the QI issue, we're basically going to say, "You're wearing two hats. You both are qualified intermediary, but you're also the buyer reseller."

And with that buyer reseller hat on, you're going to issue a note to the partnership. That note is boot, but it's installment note because it's going to say 90% payable shortly after closing, 10% payable January 2 of the following tax year. So we qualify it as an installment note. And in that situation, the installment sale rules say if the partnership distributes that note to the partner who wants to be cashed out, there is no gain recognized on that distribution. Rather the exiting partner steps into the shoes of the partnership to recognize the deferred gain on the installment note. So a nifty technique for cashing a partner out, you've got to get their agreement that they're going to be willing to wait until the following year to receive some of their cash. A little wrinkle on that, and Michael touched on it since the ban, gain the 25% unrecaptured section 1250 recapture comes out first, that's going to fall on the hands of the cash-out partner here.

So you might want to have to do something else within the partnership to take into account that additional tax, the higher rate that gets established for the exiting partner. But we have solved our problem of getting cash to the partner who wants to cash out and not having gain to the two partners who want to stay in and do an exchange. So at the end of the day when the dust settles, the exiting partner has the cash, partners one and two have exchange funds with the QI, they can now go out and buy their replacement property. Wrinkle to keep in mind here however is the partnership has to replace all of the debt, not just two thirds of the debt. In this example, they only have to place two-thirds of the equity because the exiting partner is getting some of the equity out and there's no gain on the note distribution, but they do have to replace all of the debt because that debt all got paid off at closing and therefore as part of the partnership equation for calculating recognized gain on the exchange.

But again, a very good technique, one thing to keep in mind, our example here, we've shown three partners, if there were only two partners and one partner wanted to cash out, we have an issue because once that partnership is down to one partner, it's not a partnership for legal or tax purposes. It's a disregarded entity. And Michael mentioned the rule that you can't have one taxpayer sell the property and another taxpayer buy the replacement property. So if it were a disregarded entity, that would be a different taxpayer. The solution there is to bring in a new partner to the exchanging partnership. So it remains a partnership for tax purposes and do that simultaneously with taking the cash out partner out. So there you're in a position where, okay, I brought in my spouse or I brought in a wholly owned S corp as a 1% partner in this partnership.

It continues with the same EIN, it's a partnership for tax purposes. It can complete the exchange by buying replacement property. So again, good technique, you're not going to find a private lender ruling precisely on point. I've had audits on this state of New York and state of California which are more aggressive in auditing 1030s than the IRS appears to be, and we've gotten no change on this. In the alternative, the actual ultimate buyer could issue the note, not the QI, but most often we see the QI issuing the note and you rely on that status of the QI as the buyer for tax purposes and the 453 rules on distributing installment notes. Next slides we're talking about a two-partner partnership. Again, they've entered into a purchase and sale agreement. So in my view, the so-called drop and swap sending out pick interest to the two partners is not viable.

Both California and New York and the states have been very aggressive in auditing last minute drop in swaps with tick interest. The IRS not so much, but they may be looking into that more. So here we are, the partnership division transaction would say neither partner wants to pay tax but they can't stand each other or maybe not even can't stand each other, they just don't want to invest together. They each have their ideas as to what a good replacement property would be. So can we say to them, "Okay, there's a way for you to divide the partnership and split up and each get your own replacement properties?" Technique we use there is a so-called partnership division transaction. The exchange starts much as any other exchange starts. You have your QI, the QI receives the net sale proceeds after repayment of debt and the exchange expenses that are approved on the sale and the QI is sitting there holding the cash proceeds just like it would in any other exchange.

But now we want to come up with a technique that allows partner one to partner two to go there separate ways in terms of buying replacement property. Again, the Michael's rule, we just can't have partner one buy a property and partner two buy a property, that doesn't work. We violate the same taxpayer rule. So what do we do? While the only asset of the partnership is what I call like-kind exchange receivable, the partnership has the right to receive from the QI either contractually under the exchange agreement has to tell you to either receive replacement property or if the exchange fails to get the cash at the end of the 180 day exchange period. So we tell the QI we're going to divide this partnership into two partnerships and each of them is going to get a piece. In this case, 50% of that QI, LTAE receivable.

Astrid Garcia: Polling Question #4.

David Shechtman: Seems all right. Here is the division transaction mapped out in this flow chart. We have to create two partnerships and to be a partnership, of course you need two partners, otherwise you are a disregarded entity. So when we do this partnership divisions and in some states you can do the divisions merely by filing paperwork. Delaware has a very generous partnership division rule that says file paperwork with the state and you don't even need to physically move assets. But here we're saying our only asset is the like-kind exchange receivable. We're going to divide the old partnership, create new partnership in fact, spin that off. Now we have two partnerships, OldCO 98% owned by partner one, 2% owned by partner two, and the flip side of that is NewCo 98% partner two, 2% partner one. Each of them has the ability to go out and acquire replacement property and acquire their own and it's not a complete divorce.

You have this little 2% tailpiece sticking out, but we pretty much satisfied their desire to go their separate ways with replacement properties. And this is an exception due to the partnership division rules, where in fact each partnership steps into the shoes of the old partnerships and says, "You are a good taxpayer for purposes of completing OldCos 1031 exchange." And you can report the exchange on old tax return even though one of the two properties was acquired by NewCo. Because NewCo under the partnership division rules is a successor and bound by the elections and the tax structure of OldCo. Again, there's no 1031 ruling right on point. There is a 1033 ruling, very similar section of the code on involuntary conversions, condemnations. Less is this technique that yes, yes, once you divide each of the two partnerships is eligible to acquire replacement property and they both count for purposes of having a single exchange.

This one also I've got on audit... Had an audit with the New York Department of Revenue where we convinced them to follow the 1033 private letter ruling and the way the partnership division rules work that this is a good solution for allowing partners to go their separate ways. Again, you have the 2% tailpiece to deal with, but throw in minority discounts and lack of liquidity discounts and presumably you can do taxable sales of those 2% interest somewhere down the road for a relatively small amount. So I know we've gone over, and I know these concepts are... If they're new to you, they may be a little bit hard to follow, but I think what is worth remembering is don't throw up your hands if you're confronted with the partnership situation or not all of them to go [inaudible 01:05:10] some of the cash out, or some of them want us to get to differently placed on properties so [inaudible 01:05:22]-

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