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FEATURE ARTICLE, JUNE 2008
THE PARTIAL SALE OPTION
The all-or-nothing 1031 exchange game can be taxing; commercial sellers should know they have another choice.
Rance Gregory
If you’re a real estate investor, broker or tax advisor, it’s a virtual certainty that you have encountered the following scenario. The owner of a property discovers the asset has appreciated substantially and decides to take advantage of a perceived selling window given prevailing cap rates or other market conditions. Or perhaps the owner has an alternative use for a portion of their trapped equity but is disinclined to sell or refinance the asset. Let’s assume the owner has an offer at a 6.5 percent capitalization rate and doesn’t believe it’ll see that pricing level again. Yet, the owner can’t locate an attractive replacement asset to complete a 1031 exchange.
At this point, the owner’s choices seem to be as follows: i) sell the property and pay a combined state and federal tax rate of roughly 15 to 30 percent (depending on the state); ii) endure the 1031-exchange process by hurrying to identify and acquire a sub-optimal piece of real estate or risk overpaying for a high-quality asset on a short timeline; iii) participate in a tenant-in-common (TIC) transaction and incur upfront fees duly earned by the TIC sponsor or iv) choose not to sell and take the chance on a similarly favorable future liquidity event.
What’s wrong with these four scenarios? All are binary. Zeros and ones. And the four options can be condensed to two if we really think about it. 1) Pay all of your taxable gain now or 2) defer all of your taxable gain. Fortunately, there is a third option for owners willing to do a little more work. Namely, to cash out some of your profits, pay a portion of your taxable gain now and defer re-investing or paying taxes on the balance. Believe it or not, this favorable option has long been provided by our beloved tax code but is dramatically underutilized by real estate owners and their tax advisors. And, truth be told, there are a variety of subtle permutations on this alternative path, as described below.
Believe or not, buyers actually can close win-win transactions with existing owners of real property that are unable to find a suitable exchange property and remain reluctant to hurry themselves to full payment of capital gains and recapture taxes. Essentially, these alternative structures involve a partial sale of the property as follows: The owner contributes the property to a new LLC formed in partnership with an institutional real estate sponsor. The owner elects what percentage of the property they would like to sell (and pays taxes on the gain above their basis) at the current time. This is typically a range of 25 percent to 75 percent ownership transfer, but can also be higher or lower. The balance of the purchase price remains in the partnership and is not subject to tax at closing. Future cash flows of the property are then split in pro rata ownership percentages. Many fund managers prefer to hold properties between 3 and 7 years. At the end of this holding period, the property would be sold and the owner would pay the balance of their tax obligation.
There is another variation of the partnership structure. In this case, the original owner, instead of receiving a pro rata equity amount, retains a preferred-equity interest in the amount of the deferred sale portion. The preferred equity earns a predetermined interest-only rate (say 6 percent) while continuing to defer the gain on the principal amount. At the end of a certain period of time (usually 3 to 7 years), the original owner would have the right to put its preferred-equity interest to the sponsoring entity at par. In this case, the structure is a way of allowing the owner to sell the property, retain a preferred equity interest earning 6 percent and continue to defer capital gains. The preferred equity must remain at risk — more on this in a moment — and can’t be in the form of a mortgage, but it does benefit from seniority to the new sponsor’s equity position. The original owner has the eventual ability to achieve liquidity by calling or redeeming the preferred equity with the put option within a mutually agreed upon timeframe.
It is important to note that the preferred-equity payments must be reasonable, market rate and within the IRS safe harbor guidelines for retained ownership interests in a disguised sale. If the owner seeks to charge an interest rate in excess of the safe harbor, the intended tax-deferred ownership position could become taxable. In other words, don’t get greedy.
Further, this preferred-equity (guaranteed payment) option only works in partnership form. Any sale involving TIC ownership shares must result in pro rata allocations of gain and loss. Most important, the transaction must have real economic substance — whether the owner merely retains a pro rata interest or preferred equity, it must be exposed to the economic risk of its respective position. The buyer of the partial interest may not in any respect guarantee the ultimate payment of the balance of the purchase price; otherwise, the entire transaction should be taxable today. The owner and buyer can contractually agree to the put option in the preferred-equity structure, but if the property fails to perform in a manner sufficient to repay the preferred equity, the owner would obviously not receive the balance of the price. This would of course be true in the case where the owner merely retained a pro rata equity interest. Like all equity positions, the owner’s retained interest would remain at risk until the property is later sold. Still, the owner is allowed to take some chips off the table in today’s volatile market, pay the tax on the cashed-out portion and keep an ownership interest in the new LLC with deferred gain on the retained portion.
For a real estate broker, this alternative method can motivate an uncertain owner to sell the property and generate a full sales commission. For tax advisors, they can assist their clients in deferring a portion of their taxable gain, while at the same time protecting the client from overpaying under a 1031 deadline or entering into a TIC if, for any reason, that structure doesn’t meet the client’s investment objectives.
You should consider that cap rates aren’t likely to fall much further and capital gains rates aren’t likely to be reduced, so property owners need to seriously consider an outright sale or at least a partial sale. For those owners with an emotional aversion to paying the U.S. Treasury, it may be time to rip off the Band-Aid® and pay the tax. This article is concerned with those owners who are seeking an alternative to the well-known solutions.
Under the partial (“disguised”) sale rules (IRS Code Section 707(a)(2)(B)), the owner benefits from the flexibility of sizing their cash distribution and corresponding taxable gain while retaining an equity interest, either as preferred equity with economic priority or as direct equity with a pro rata share of potential future upside. The downside is a potential loss of control over day-to-day decisions related to the property. Many institutional buyers will require control over major decisions. This loss of control also occurs if the owner participates in a large syndication or TIC structure.
The benefit to the buyer is unlocking a proprietary transaction that would not otherwise occur without the strategic tax solution. And since the buyer is providing the time value of a tax-deferral benefit, one could argue the pricing should be slightly better than an outright 100 percent fee purchase at market.
Since this alternative scenario is hard to imagine in the abstract, let’s look at some sample arithmetic. Option 1 (an outright sale) assumes the owner has a property worth $10 million, with $6 million of existing debt. Therefore, the owner would have $4 million of equity before taxes in an outright sale. We do need to consider the owner’s outstanding tax basis. Let’s assume a tax basis net of depreciation of $5 million. After paying an assumed combined tax rate of 25 percent, the seller would net $2.75 million.
Compare this with Option 2 (partial sale), in which the owner sells a 25 percent interest in the property to a new buyer for $1 million. In this case, only $312,500 in tax is due upon closing, so the seller has a total net value, earned ($687,500) and retained ($3 million), of $3,687,500. Obviously, the seller will have additional taxes to pay upon future sale or redemption of any partnership interests. In the interim, however, the seller is experiencing a significant tax deferral benefit and continued cash flow from their 75 percent interest.
Option 3 involves a 75 percent sale and leaves the owner with an earned ($2,062,500) and retained ($1 million) value totaling $3,062,500. In this case, the seller will benefit from a 25 percent continuing ownership interest. In Options 2 and 3, the owner should, in fact, make a better overall return (through a net present value benefit) by cashing out a portion of their equity today and remaining in the deal than they could earn by selling outright, paying 100 percent of their taxable gain and reinvesting the proceeds.
Clearly, these examples are extreme simplifications of a complicated tax analysis. A proper analysis would also consider the impact of any refinancing proceeds, whether any existing or proposed property debt is qualifying or non-qualifying under the disguised sale rules, among other factors.
In many cases, the property may be carrying less debt than a new buyer would typically employ. In these situations, the buyer may seek to refinance the property and use all or a portion of the refinancing proceeds to acquire the seller’s interest. The above example assumes that the seller has been relieved from its proportionate share of existing loan proceeds. If the property carried only $3 million of debt and a new buyer wanted to place $6 million on the property, the parties would need to determine the best application of the $3 million in incremental debt proceeds. In any event, the debt obligations would continue to be split pro rata, so the original owner needs to be comfortable with the total level of debt and take comfort in the sponsor’s ability to manage the property — no different in this regard than participating in a TIC or syndication structure.
Despite all of these considerations, economic and otherwise, one would hope that as the market continues to evolve and increase in sophistication, seller decisions can become informed by more than the current two-item menu: sell and pay the entire taxable gain today or don’t sell and defer the entire taxable gain. Real estate, like life, is much more complicated than that. Economic theory instructs us to maximize our utility. Many will be surprised to know that the partial sale rules embedded in our tax code actually help in this regard.
Rance S. Gregory is the chief executive officer of NBS Real Estate Capital, a Portland, Oregon-based investment management firm.
*None of the above should be taken as tax advice specific to any individual party. Each owner’s tax situation is unique and they should consult with their own tax advisors before making any decision.
©2008 France Publications, Inc. Duplication
or reproduction of this article not permitted without authorization
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