Real estate investors who own several investment properties, each within individual partnerships, may seek to diversify their holdings to spread risk, maximize returns and secure their long-term financial stability.
One strategy to achieve this is by contributing real estate to a multiple-property real estate fund in exchange for partnership interest. It’s critical to consider the potential implications of disguised sale rules under IRS Regs Sec. 1.707-5 when restructuring a partnership, as the rules may impact the transaction’s tax treatment.
Under Sec. 721, contributing property to a partnership for interest in that partnership will generally result in no recognized gain or loss. However, Regs. Sec. 1.707-5 states that contributions of property may be deemed a disguised sale if the contributed property is subject to a liability other than a qualified liability.
As a result, it's crucial to exercise caution while transferring encumbered property in a partnership restructuring transaction, as the nature of the liability being transferred must be examined to ensure it qualifies.
Here are examples of qualified liabilities:
- A liability that was assumed by the partner more than two years prior to either the date written agreement is made to transfer the property or the date the property transfers to the partnership, whichever is earlier.
- A liability incurred within the two-year period, but that wasn’t made in anticipation of the transfer.
- A liability in which the proceeds of that liability were used by the partner to fund capital expenditures.
- A liability that was incurred in the ordinary course of trade or business, but only if all assets related to the trade or business were also transferred to the partnership.
Investors who make property contributions should also be aware that any consideration received could trigger a portion of the qualified liability to be treated as consideration. For this reason, it’s better for a receiving partnership to avoid giving cash to the partners in addition to partnership interest, to avoid taxable treatment of the transfer.
There are four exceptions that can mitigate the impact of a disguised sale when cash is paid to partners:
- Reasonable guaranteed payments
- Reasonable preferred returns
- Operating cash flow distributions
- Reimbursements for preformation expenditures (i.e., costs associated with acquiring, constructing or improving land, buildings and equipment)
The contributing partner can potentially utilize the preformation expenditure rule to withdraw a part of their historical equity in the contributed property by employing debt financing to make capital improvements to the property before transferring it to the partnership.
Real estate partnership restructuring can be complex and when not handled correctly, may result in the loss of potential tax benefits.
For analysis of and advice about your restructuring transactions, contact the Mazars team.
John Ohannessian, Tax Partner
Phil Haas, Tax Senior