Hidden Dangers of Partnerships and the 1031 Exchange

The Section 1031 “like-kind” exchange is a legal tool utilized by many investors to upgrade their real estate holdings while deferring taxation. Theoretically, investors can exchange properties indefinitely without incurring capital gains tax. However, complications can arise when these investments are made by partnerships. It is almost inevitable that somewhere along the process, a partner will want to “cash out” their investment. This can expose the entire partnership to substantial tax liabilities.

If in order to satisfy the exiting partner, the partnership’s property is sold and proceeds distributed, the remaining investors will be subject to substantial taxation on any gains. Simple strategies, such as “buying out” the exiting member or specially allocating the gain, also subject the partners to taxation. However, several options are available to a partnership facing dissolution. These include the “drop and swap”, the “swap and drop”, the “split-off”, and the installment note. With appropriate planning a transaction can be structured that satisfies both parties.

For partnerships that have seen their dissolution ahead of time, the “drop and swap” can be of great use. In this scenario the partnership makes a tax-free distribution of the investment property’s title to the individual investors. Once the individuals possess title, each investor may “cash out” or make a like-kind exchange. The key to executing this strategy is ensuring compliance with Section 1031’s “held for investment” requirement, thus this strategy requires considerable foresight.

If investors do not recognize the tax issue until just before the property is disposed, a “swap and drop” may be effective. This strategy resembles the “drop and swap” but is ordered differently. Here the partnership executes a like-kind exchange, waits to avoid IRS treatment as a “step transaction”, and then drops title to the individual partners or refinances the new property to acquire cash to redeem the leaving partner.

Alternatively, a “split-off” strategy may be effective. In a split-off, the partnership distributes tenancy in common title to the exiting partner only, then the partnership makes an exchange in its name. Since the partnership keeps title in its name, the split-off provides title continuity, satisfying the “held for investment” requirement and allowing the leaving partner to cash out or exchange their interest.

Finally, the investors may sell the original property for cash and an installment note. In this approach the partnership distributes the exiting partner an installment note equal to his interest while the remaining investors receive cash. The remaining partners use the cash to exchange into a new property and the exiting partner only recognizes gain as note payments are received.

The like-kind exchange provides real estate investors with a valuable wealth-building tool. But if the partnership dissolves, serious tax issues arise. Fortunately, with proper planning these risks can be minimized and transactions can be structured that maximize returns for all the partners.

Aaron M. Gregory, JD/MBA Contributed to this Article.

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Interview: Telly Fathaly

For this weeks blog I interviewed Telly Fathaly, Vice President at Sterling Real Estate Capital.

1.) Hi Telly can you tell us a little about yourself and Sterling?

Thank you for this platform to communicate with your readers. Sterling Real Estate Capital, LLC is a Private Equity Advisory Firm that specializes in raising cash for Commercial Real Estate transactions. We serve as an intermediary between high net worth / institutional investors and operators / owners of Commercial Real Estate. Our team has an extensive industry background with principal, private equity, brokerage and Wall Street experience. We have a diversified and updated base of investment contacts and relationships that provide us with insight into the rapidly evolving attitudes and appetites of the Private Equity landscape.

2.) What opportunities currently exist in the commercial real estate space?

From our perspective the top opportunity we’re seeing is the ability for qualified operators to establish Programmatic JV partnerships with institutional investors outside the traditional fund construct. This is a departure from the last cycle where fund managers held more operating control over money being deployed by institutional groups. Whether we’re speaking about separate accounts, pledge funds or a more standard programmatic JV arrangement, the benefits to the operator can be significant. Most of the groups we work with are able to more effectively attract deals and concentrate on execution rather than scramble to raise money for individual opportunities. They’re able to jump out in front of problems and issues ahead of time, allowing for the benefit of playing offense in a market beginning to provide real opportunities for groups that are correctly capitalized.

3) How do commercial brokers work in cooperation with Sterling?

Commercial Brokers are an essential part of our success and it has always been important for us to incentivize client and deal referrals to facilitate continued relationships. Our reputation in this regard is outstanding and we can provide clarity as to broker participation very early in our process.

4) What is your "sweet-spot" of transactions?

Our “sweet spot” consists of a specific type of organization rather than a particular transaction. Our top clients and prospects all have one thing in common, an ability to grow and improve as the realties of our industry continue to manifest. We’re looking for the companies that have what it takes to survive and thrive and help provide them with the cash that will fuel their growth. There’s a window of change and opportunity opening for an undetermined period of time right now. The groups able to solve their problems and get organized will be able to step up to a new level over the next couple of years. We’re already seeing it happen.

5) What asset classes do you like in 2010?

Investors don’t seem to be as particularly focused on asset classes as much as they are on asset specific factors. We’ve seen two types of approaches emerge. The first is a more familiar return driven short-term play. This usually consists of solid real estate in A locations where some sort of circumstance has provided a chance to acquire at an attractive basis. The second is a renewed emphasis on more fundamental strategies of longer investment periods and increased attention to equity yield from cash flow. This is a departure from LP’s who were previously focused on value generation exclusively being quantified by IRR. Here the investors, mostly high net worth family offices, are buying cash flow at a discount and expecting a premium to account for the risks of Real Estate.

6) What are Institutional Investors Looking for from Operators in 2010?

Institutional Investors are looking for experienced operators with expertise in a specific product type and / or geographic area. Equity co-investment and “alignment of interests” has become a key consideration with debt capacity and ability to provide guarantees if necessary. Finally, operators should have a good network for originating off market transactions and provide investors with compelling and unique opportunities.

Please feel free to call or write with any questions or feedback.

Email: telly@sterlingrealestatecapital.com

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1031 Exchange Case Study Update- Oil and Gas

The Benefits of Oil and Gas Royalties:

In the past three months Exchange Solutions Group has been witness to a most interesting and ingenious trend. A group of savvy local real estate investors, who owned fully depreciated rental property (Adjusted Basis of practically Zero), desired to defer Capital Gains but lacked the optimism to reinvest locally in rental real estate. To solve this problem, these investors bought oil and gas royalty interests that qualify for 1031 exchange treatment (yes, royalties are "like-kind" with rental real estate). These investments were cash flow rich and chock-full of depletion (depreciation's equivalent in the mineral interest world). Thus, in one fell swoop, investors were able to defer their Capital Gains taxes, obtain property with strong cash flows, AND inherit fresh, tax deductable depletion schedules.

The lesson to be learned is that creativity can be a key component of a successful 1031 exchange. Who says you have to trade office space for other office space, or land for land? No one! Under the correct structuring, the 1031 tax exchange can be quite flexible and fit many needs.

For more information about Oil & Gas Royalties and the 1031 Exchange, click here.

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General Growth Bankruptcy: Real Estate’s Foundations are Shaking

General Growth’s bankruptcy shakes the foundations of the commercial real estate market, and the financing documents that hold it up. The bankruptcy plot touches on a wide range of issues, from the sacredness of corporate entities to director independence to the prevalence of Delaware entities. The GGP plot, thus far, ends at a place that is a happy one for developers and a cautionary one for lenders. Before getting into the specifics, it’s worth noting the overall impact: commercial real estate and its financing structures will never be quite the same.

As background, complex entity structuring pervades the commercial real estate market, from large mall owners such as Simon Property Group and General Growth to more regional investor-developer types, such as Tishman Speyer and the Bonaventure Group. Motivating this are both structuring factors and financing drivers.

From a structuring perspective, commercial real estate holding companies typically have asset organizational charts as complex as an ultra-modern family tree, with different sets of parents, abundant offspring, and multiple sets of grandparents. This structure originates in the need for 3 things: investment facilitation; capital structure layering; and liability reduction. A note as to the latter: liability-shy real estate developers work to mitigate environmental, financial and other legal liability via LLC formations intended to protect the mother-ship or personal family financials from each property’s unique set of risks.

For my entire article click here.

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LandAmerica Settlement Leaves Guidance on How to Handle Proceeds

Imagine waking up one morning and getting a call from your bank informing you that for every dollar you had, you now have quarters. In other words, there is only 25% of your cash left. This horrible scenario is now dawning over many former LandAmerica 1031 exchange customers and they may have little choice but to accept.

Close to 350 former LandAmerica customers had until November 10 to vote on a plan which would have split the proceeds of a bankruptcy ruling according to the type of 1031 exchange agreement they had in place (A U.S. trustee has filed an objection to the ruling which has delayed proceedings). Customers who set up non-segregated plans would have received only $0.25 for every dollar held, those with segregated accounts would have received $0.70, and those who specified their funds be held in an escrow account would have received $0.97.

The reason this tragedy came about was that those customers in LandAmerica without segregated accounts essentially had their money commingled with other customers’ exchange assets. This cash was then used for investment purposes, in this case, auction rate securities which eventually were frozen. As unimaginable as it may seem, this sort of account process is commonplace among many large corporations who facilitate 1031 exchanges. Once your money is handed to them, unless you have asked the question or direct the QI yourself, your cash is dumped into the communal pool of assets. More importantly, you have the worry that the exchange group does not have any knowledge of where the money is held. Your money may be wired to “Treasury Services” such as what happened at LandAmerica.

What has emerged from this case is that you can obtain the same protection for you assets by having the appropriate contract language in place and making sure your proceeds are in separately identified accounts (which ES Group uses 100% of the time). Had this been done, LandAmerica customers would have been able to obtain higher recoveries. Of course, hindsight is always 20/20 and this provides little consolation to those who have seen their wealth disappear. Cases like LandAmerica demonstrate who you do business with and how you do it, is of paramount importance.

At Exchange Solutions Group, we have always ensured our customers’ investments were safe through allowing customers to identify their own bank in which their money will be held. Though it may seem obvious, this option is not available at most other 1031 exchange corporations. By allowing customers to choose their own bank we allow them to introduce a third party (a banker) who is separate from the exchange and can ensure their investments are alone in a separately identified account. The essence of the 1031 exchange is to defer capital gains taxes and continue your investment; this becomes a failed strategy if it’s derailed by poor corporate decision making, or alternatively not knowing what pitfalls to lookout for!

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Watergate: Symbol of Two National Crises

When someone mentions Watergate, I instinctively think of the Nixon scandal and how that event highlighted and even symbolized the problems our country faced. Government was not to be trusted and our leaders were, contrary to their protests, crooks. Even though the event itself was relatively minor and as the subsequent 1972 election results proved, completely unnecessary, it was a microcosm of all that ailed the nation.

Today I read another story about Watergate, this one about how the hotel part of that complex is about to be sold for around $40 million after its previous owner, “an affiliate of Monument Realty, a Washington D.C. developer, and an affiliate of Lehman Brothers Holdings inc.” defaulted on their $43 million dollar loan. They had planned to redevelop the property “into a boutique hotel with some condominium units”. This story seems to feature all the major players of our current crisis: defaulting loans, foreclosure auctions, and of course Lehman Brothers.

The tale seems all too common and unfortunate, a group over leverages itself on a loan for a building, attempts to redevelop it, then defaults as the credit crises hits. Except here it takes place in our nation’s capitol, with regard to an iconic building, which at one point in time was the symbol of high end property. It is an amazing microcosm, reflecting the fall from grace that has befallen our real estate industry. One has to wonder at how a singular building can find itself mirroring the woes of a country so perfectly on two separate occasions.

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