By Ronald A. Shellan, Miller, Nash, Wiener, Hager, & Carlsen LLP
Many taxpayers exchange into bare land for the purpose of developing it with a group of partners. The land is frequently transferred to a partnership or limited liability company so that the additional financial and development resources can be utilized to develop the property. An alternative that can ensure tax-free exchange treatment is to structure the partnership using a long-term lease.
Tax practitioners are finally beginning to realize the very significant tax risks in immediately transferring replacement property received in a tax-free exchange to a partnership or limited liability company. Although Magneson v. C.I.R. 753 F2d 1490 (9th Cir 1985) held that such transfers did not cause an exchange to be taxable, Magneson may no longer be valid law. There are several reasons why; chief is the court's reliance on case law--since explicitly overturned by Congress (see IRC ยง 103 1 (a)(2)(D))--that an exchange of real property for an interest in a partnership that owned real property qualifies as a tax-free exchange.
Let us assume that a taxpayer plans to transfer replacement property valued at $500,000 received in an exchange to a partnership with Joe Developer. The partnership will pay a preferred return to the taxpayer of 8 percent on the taxpayer's $500,000 capital account. The partnership will borrow $2 million to develop a building on the property. The other partner, Joe Developer, will not put in any cash, but will receive a $250,000 development fee. The balance of any profits will be split equally. Assuming that the property would sell for $4 million in ten years, the proceeds would be paid as follows:
- $2,000,000 to repay loan;
- $500,000 to repay taxpayer for his land capital contribution;
- $250,000 to repay Joe Developer for developing the property;
- $1,250,000 to be split equally between the taxpayer and Joe Developer.
This structure, however, exposes the taxpayer to the argument that he did not hold the replacement property for investment and that in effect the taxpayer exchanged real property for an interest in a partnership (which does not qualify as a like-kind exchange). What is a taxpayer to do? The taxpayer wants to complete his exchange without tax risk, but he also wants to contribute the property to a partnership.
An attractive alternative is for the taxpayer to lease the property on a long-term lease to the partnership. The lease can provide that the taxpayer (as landlord) will subordinate to construction and permanent financing. The lease payments will be 8 percent of $500,000 (the same as the preferred return on the taxpayer's capital account if the transaction had been structured as a partnership) and might be limited to cash flow of the partnership. If the partnership wishes to sell the project, it can have an option (which can be assigned to the property buyer) to purchase the property from the taxpayer for $500,000. Thus, the distribution of the $4 million in proceeds on sale of the property would be the same as set forth above except that the $500,000 payable to the taxpayer as a capital contribution will be payable to the taxpayer as proceeds from the sale of the property. The only economic difference in the two transactions is that there is no obligation on the part of the partnership to exercise its option.
There are a few cautions and twists. The first caution is that the IRS might get very sophisticated and take the position that this is really not a lease, but that in fact the partnership is the owner of the property. It could thus destroy the exchange. This is possible, but there appear to be enough legal differences to convince a court that the transaction creates a lease relationship and not a partnership relationship. An additional caution, for property such as a motel or hotel that qualifies as active trade or business real estate, for which tax losses are not subject to the passive loss rules, is that leasing the property will cause the lease income to be converted to passive income that is subject to the passive loss rules.
A twist is to structure the transaction as an improvement exchange. For example, assume that the taxpayer needs to improve the property to cover the sale of a $2 million piece of property. Structuring for this type of transaction can get quite complicated. But it can be and has been done successfully.
And finally a bonus! When the project is eventually sold, at least some of the proceeds, $500,000 from the exercise of the lease option by the partnership, can be used by the taxpayer as part of a new tax-free exchange. In general, it is very difficult to sell property in a partnership and ensure that each partner can reinvest the proceeds tax-free in other real estate.
Using a long-term lease to solve tax-free exchange problems is a creative solution for one of the most vexing problems for a real estate tax lawyer. But it can create significant additional complexity in structuring and financing, the partnership.
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