Editor: Mark Heroux, J.D.
Instead of having a single real estate property housed under a stand-alone partnership entity, there is a trend toward diversification in a real estate portfolio with multiple properties. This can be accomplished by contributing property to a real estate fund or to an umbrella partnership real estate investment trust (UPREIT) that traditionally holds multiple real estate properties, in exchange for a partnership interest in that entity. With these restructuring transactions, careful consideration is needed to prevent the transaction from being deemed a disguised sale.
Under Sec. 721, the general rule is “[n]o gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.” However, there is the potential of a disguised sale under Regs. Sec. 1.707-5 when encumbered property is contributed. Under this regulation, if a partnership assumes or takes property subject to a liability other than a qualified liability, the partnership is treated as transferring consideration to the partner. As such, when transferring encumbered property in a partnership restructuring transaction, care must be taken to determine whether the liability transferred is considered qualified.
As defined in Regs. Sec. 1.707-5(a)(6), a qualified liability is:
- A liability incurred by the partner more than two years prior to the earlier of the date the partner agrees in writing to transfer the property or the date the partner transfers the property to the partnership, and that has encumbered the transferred property the entire time;
- A liability that was not incurred in anticipation of the transfer of the property to a partnership but that was incurred by the partner within the two-year period previously mentioned;
- A liability that is allocable under the rules of Temp. Regs. Sec. 1.163-8T (“tracing rules”) to capital expenditures (as described under Regs. Sec. 1.707-4(d)(5)) with respect to the property;
- A liability that was incurred in the ordinary course of the trade or business in which property transferred to the partnership was used or held, but only if all the material assets related to the trade or business are transferred to the partnership; and
- A liability not incurred in anticipation of the transfer of the property to a partnership but that was incurred in connection with a trade or business in which property transferred to the partnership was used or held, but only if all the material assets related to that trade or business are transferred to the partnership.
If any consideration is given to the partner as part of the restructure transaction, a portion of the qualified liability can also be regarded as consideration. This would be calculated only to the extent of the lesser of:
- The amount of consideration if the liability were not a qualified liability; or
- The amount obtained by multiplying the amount of the qualified liability by the partner’s net equity percentage with respect to that property.
As such, the stand-alone real estate partnership entity should avoid giving its partners cash in addition to a partnership interest in either the real estate fund or the UPREIT to prevent a disguised sale on the qualified liabilities.
Moreover, to further help avoid consideration of a qualified liability as non-qualified, the partner can make a capital contribution to the partnership prior to the restructure partnership transaction’s taking effect. This will reduce the amount of consideration the partner is deemed to have received.
Lastly, four exceptions can alleviate the impact of a disguised sale when a partner receives cash or other consideration from the partnership, even if the disguised sale is made within two years of a transfer by a partner to the partnership. These exceptions include reasonable guaranteed payments for capital, reasonable preferred returns, operating cash flow distributions, and reimbursements for preformation expenditures.
For real estate partnership restructure transactions, most often, the exception for preformation capital expenditures is used. Such expenditures can include costs incurred to acquire, construct, or improve land, buildings, and equipment. What qualifies for this exception is the amount incurred during the two-year period before the transfer by the partner to the partnership, limited to 20% of the fair market value (FMV) of such property at the time of the transfer. The 20% limitation does not apply if the FMV does not exceed 120% of the adjusted basis of the property at the time of the transfer. This is applied on a property-by-property basis.
With the desire for greater diversification in real estate holdings, standalone real estate partnerships are moving toward contributing their property, in exchange for a partnership interest, to a real estate fund or an UPREIT that holds multiple real estate properties. Most often, the property contributed is encumbered by debt. In this case, careful attention is needed to evaluate the liability to determine whether it is considered qualified or nonqualified. Also, the partnership should avoid providing the contributing partner additional consideration on top of a partnership interest in the new partnership entity. These measures will help prevent the partnership restructuring transaction from being deemed a disguised sale.
Editor Notes
Mark Heroux, J.D., is a tax principal in the Tax Advocacy and Controversy Services practice at Baker Tilly US, LLP in Chicago. Contributors are members of or associated with Baker Tilly US, LLP. For additional information about these items, contact Mr. Heroux at mark.heroux@bakertilly.com.
