A like-kind exchange is a transaction or series of transactions that allows for the disposal of an asset and the acquisition of replacement asset without generating a current tax liability from the sale of the disposal. A like-kind exchange, for example, can involve the exchange of equipment for other equipment or one real estate investment property for another real estate investment property. Among the many tax planning opportunities in real estate, like-kind exchanges provide the most significant tax benefit. The following are some strategies to get your next deal done.
Exchanging Into Tenancy-in-Common Interests
In general, like-kind exchange rules require that the taxable entity that sells real estate in a like-kind exchange must be the taxable entity that acquires the replacement property. This becomes an issue when the entity wishes to reinvest sale proceeds into a new joint venture that acquires the replacement property. In this scenario, the joint venture entity is formed to hold title to the real estate, establish an economic relationship between parties, and separate legal liability. Unfortunately, a like-kind exchange cannot be completed in this manner, as the initial sale would be taxable. Instead, a like-kind exchange can be completed by taking an interest in the replacement property via a tenancy-in-common (TIC).
Basically, a TIC is a legal form of property ownership in which each owner has a separate fractional and transferable interest. Thus, when a taxable entity sells property, it can successfully complete a like-kind exchange by acquiring a TIC interest in replacement property. Considerations under this structure include having an extensive TIC agreement, and making sure the lender is satisfied with the TIC structure.
Partner Exit After Promote
A key term to a real estate transaction is the sponsor “promote”. The typical joint venture agreement between a limited partner and a general partner often includes an equity waterfall with a promote structure. A common promote model includes the following:
- First, distributions to partners pro-rata until all partners have received an Internal Rate of Return (“IRR”) of 8%;
- Second, distributions to partners pro-rata until all partners have received their total capital contributions; and
- Lastly, distributions to partners are such that (i) the general partner receives 20% of all remaining cash flow, and (ii) the limited partner receives 80% of all remaining cash flow.
This model applies to an outright sale, but is it possible for a partner to liquidate their interest for cash without harming the tax-free position of the other partners? The short answer is, yes.
This type of transaction begins with a carefully crafted operating agreement, and the tax section of the operating agreement must, (i) comply with Section 704 of the Internal Revenue Code (“IRC”); and (ii0 require that liquidating distributions are based on a partner’s positive capital account.
There is little case law on this issue. Also, there are many non-tax issues to consider. Will the partners agree to the exit? Will there be new partner admissions? Will the lender be comfortable with the remaining partner pool? This type of transaction should be examined in great detail by professionals with deep expertise in partnership tax law and real estate law.
A Rule Of Thumb?
Real estate executives looking to quickly analyze a like-kind exchange often offer the following advice, “Eddie, listen… it’s simple… to be tax-free, you go up in equity and up in debt.” This old adage often rings true. But, what happens when your debt decreases? What if the debt you are paying off is greater than the debt you are acquiring?
In this situation, the transaction may be tax-free. Consider a property sale with a fair market value of $100k and debt of $50k. Now, suppose that the replacement property is purchased at $110k with debt of $45k. This transaction might actually be tax-free because the additional cash needed to close the deal is greater than the net decrease in debt. Every deal is different -- don’t let an old adage squander a tax deferral opportunity.
A like-kind exchange is a complex transaction that requires proper guidance in order to take advantage of the tax break, so speak to your tax advisor before your next deal.