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The Creative Use of Section 1031 Exchanges in Partnership Situations

Steven P. Katkov Cozen O’Connor

Minneapolis

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TABLE OF CONTENTS

I. INTRODUCTION .............................................................................................................. 1

A. Business Considerations for Entity Selection ......................................................... 1

B. Tax Consequences of Entity Selection ................................................................... 2

II. Section 1031 of the Internal Revenue Code and Partnership Interests ............................... 4

A. Introduction ............................................................................................................. 4

B. Partnership Interests Are Expressly Excluded ........................................................ 8

III. Creative Solutions to the Partnership Issue under Code Section 1031 ............................. 11

A. Revenue Ruling 99-6: Direct Exchange of Partnership Interests ........................ 11

B. Indirect Exchange of Partnership Interests under Code Section 721: The upREIT .......................................................................................................... 14

1. All OP Units to Selling Partnership. ......................................................... 15

2. Cash and OP Units to Selling Partnership. ............................................... 16

3. Potential Gain Recognition by Equity Partners upon Property Transfer. . 17

4. Ultimate Gain Recognition by Equity Partners. ....................................... 18

C. Partnership Break Ups – Divorce Law for Partners .............................................. 19

1. The “Drop and Swap”, or Co-Tenancy as a Solution ............................... 19

2. The “Swap and Drop” ............................................................................... 25

3. A Common Challenge to Either Form of Partnership Breakup – Same Taxpayer Rule ........................................................................................... 28

D. Exchange for Property, Plus Installment Note. ..................................................... 31

E. Special Allocations – The Arranged Marriage ..................................................... 31

IV. Conclusion ........................................................................................................................ 32

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I. INTRODUCTION1

A. Business Considerations for Entity Selection

The ownership structure governing real property assets can have profound implications for the success of nearly any investment. While individual ownership of real estate provides the greatest operational and management flexibility, few owner/operators would hold title to any income producing property in their individual capacities, opting for the protections against personal liability afforded by the corporate form of ownership. Moreover, lenders prefer that projects are legally held within entities that survive the departure or arrival of the individual owners over the entity’s lifecycle and that are also bankruptcy-remote. Consequently, the majority of real estate investors own income properties through a form of business entity. In most respects, it is legal malpractice to suggest otherwise.

In addition to legal considerations, corporate ownership of real estate allows for the creation of a winning project, where the contributions from each investor might include any combination of financial resources, access to capital markets, and strong market knowledge and strategy that create synergies for the group. A team of experienced, savvy investors is required to even gain entry into a new hot market. And, there is really no substitute when pitching a new development plan to municipal officials for having an experienced team with significant local credibility. In the end, the team will usually select a structure based on the number of desired or anticipated investors, the degree to which investors desire to actively participate in the operations and management, the risk appetite of investors and tax planning considerations. Going it alone, while attractive for a variety of reasons, is simply a passing fancy in the U.S. due to the limited ability of most developers to raise capital for their project, not to mention that most risks inherent to the sole proprietorship approach to real estate development are simply not insurable ones. The risk-reward calculus is decidedly tipped in favor of multiple investors in the majority of projects.

The entity vehicle of choice is driven by these business considerations. A small group of investors in a real estate project that is not capital intensive might share management of the investment in a general partnership or tenancy-in-common arrangement in which the risk of loss is acceptable should the project fail or contingent liabilities arise. A larger group of investors might envision passive involvement by many and therefore select a manager-managed limited liability company or a limited partnership structure, in which most investors are insulated from operational risk and any liability exposure is limited to the investor’s ownership interest in the underlying property. Still others seek to participate as passive investors in more sophisticated portfolios managed by professionals through a real estate investment trust (REIT) that by design attracts large amounts of capital from hundreds, if not thousands, of investors having no right to participate in operations or management in return for solid performance in the

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marketplace2 and in which risk of loss is limited to the amount of their investment.

B. Tax Consequences of Entity Selection3

The Internal Revenue Code (Code)4 does not treat all such business entities on equal footing, however. The distinct forms of business entity in which investors hold title to real estate receive very different tax treatment under the Code. For most owner/operators, the primary objective is pass-through tax treatment at the entity level,5 followed in priority by the flexibility to structure the partnership to include multiple classes of equity rights that may involve other entities as owners. For a variety of reasons, a limited partnership, limited liability company or other entity considered a “partnership” for federal tax purposes will typically constitute the entity of choice for the operation of real property.6 While an extensive discussion of such matters is beyond the scope of this breakout session, inclusion of debt in a partner’s basis for purposes of recognizing losses, pass-through taxation of gains and income, and the opportunity for tax deferred current and liquidating in kind property distributions are major factors which make the partnership preferable in most instances. Assume, for example, that a single-asset LLC holding an apartment building worth $15 million and a tax basis of $9 million is owned equally by two partners who want to “divide up” the partnership and go their separate ways by acquiring their own properties in single-member LLCs. If the LLC may be divided equally such that no “true-up” contribution is required by either partner, the partners can generally carry out the desired transaction without triggering an income tax consequence to either the LLC or to its members.

The potential problem with a general partnership is that all general partners are jointly and severely liable for all partnership obligations, including, for example, tort liability resulting from a physical injury accident not fully covered by insurance. To limit liability exposure, investors often select the limited partnership form of business entity, in which only the general partner is liable for partnership obligations (but even here, the general partner can be a corporation or an LLC that offers its owner limited liability protection). Of course, the most popular form of entity is the LLC. Absent an election to treat the LLC as a corporation for tax purposes, a single-member LLC will be disregarded for income tax purposes (i.e., the sole member is deemed to own the assets of the LLC rather than an entity interest); it will be treated as a partnership for income tax purposes if there is more than one member.7 Partnerships (including LLCs treated for income tax purposes as partnerships) do not have the deemed asset sale problem associated with corporations, and as a general rule may distribute property to owners without triggering an income tax.8

A distinct advantage to this form of business entity are the rules permitting allocation of income, gain, loss and deduction among partners and members as is specified in the partnership or LLC agreement9 provided such allocation has “substantial economic effect.” The Code provides a substantial amount of leeway

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in allocating such items among the partners or members. If the allocation has substantial economic effect, the overall ownership percentage of the member in the LLC makes no difference in the allocation of the LLC’s profits and losses. The ability to allocate income, gain, loss and deduction among the members of an LLC with respect to particular items in a manner different from the members’ overall interest in the LLC allows an LLC to be tailored to reflect the overall business arrangement among the investors and their economic rights and burdens.10

For federal tax purposes, partnership treatment allows each member of an LLC to account for his or her share of the income, loss and credits of the business entity. The profits are taxed as they are earned, not as they are distributed. Such income increases each member’s tax basis in the LLC, and this in turn means that distributions to owners are generally tax-free reductions of basis. Members are taxed only on distributions of cash that exceed the member’s adjusted basis in the membership interest. As such, the flexibility provided by the partnership allocation rules facilitates real estate investment transactions.

LLC entities offer the same single layer of tax advantage when the business entity liquidates. The sale of business assets and subsequent distribution of the proceeds to the member in return for his or her membership interest is a taxable event, and generally this gain or loss is capital in nature. The gain on the sale of LLC assets flow through to the members and is taxable at their marginal tax rates. This recognized gain in turn increases the adjusted basis of the member’s interest in the LLC, so that when the cash is eventually received from the LLC in return for the member’s interest, further gain is not recognized. Thus, there is no double taxation at liquidation of the LLC. The same result occurs if the assets are distributed directly to the member; gain or loss is measured by the difference between the fair market value of the assets distributed and the basis of the member’s interest.

These features are generally unavailable for Subchapter S corporations,11 for instance, even though, as a general rule, an S corporation is a flow-through entity as is a partnership or LLC.12 Yet, many new real estate investors seem obsessed with Sub S corporations from information they have gleaned from the internet or heard from friends over coffee. While the “Sub S” structure may provide more favorable treatment with respect to potential self-employment tax liability13, the structure provides no real advantage to ownership and operation of income producing real property because rental income is exempt for self-employment taxes.14 A distinction in wording between Code Section 707(b)(2)(sale of property that is not a capital asset) and Code Section 1239(a)(sale of property which qualifies for depreciation) makes the Subchapter S corporation the appropriate vehicle to achieve capital gains rather than ordinary income in certain transaction where property is sold from an “investor” party to an affiliated “developer”. Transactions of this nature could involve the conversion of investment apartments to condominiums held for sale, or the conveyance and subdivision of raw land15 for multifamily development. Because Subchapter S does not have a comparable

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provision in the Code, this technique permits the seller to transfer real estate to a related but not controlled S corporation. But other than these very limited transactions, the investment vehicle of choice is the entity that receives partnership tax treatment, particular since Code Section 707(b)(2) only applies if the transferee-partnership is controlled by the seller, selling the property to a non-controlled partnership.16

For all the reasons noted above, partnerships and LLCs are much better vehicles in which to hold appreciated real estate. In addition, tax partnerships can be structured with multiple classes of equity rights, and may involve other entities as owners. These features are generally unavailable for S corporations. The Subchapter S structure may provide more favorable treatment with respect to potential self-employment tax liability, but since rental income is exempt for self-employment taxes, this advantage applies primarily to development, brokerage and management fee-for-service activities which are expected to produce ordinary income.

Accordingly, the traditional Subchapter C Corporation is a disfavored entity because of the issue of double taxation (not to mention tax rates at the corporate level ranging from 15 percent to 35 percent). Once the income is earned by the C Corporation, the corporate level tax is applied. Then, as profits are distributed to shareholders, the profits are taxed once again as dividend income. This double taxation is avoided if the entity operates as a partnership or an LLC taxed as a partnership. The Code does not impose entity-level taxation on these entities; rather, entity income simply flows through to the owners and retains its character.17 It is because of the favorable tax treatment of partnerships that most real estate developers and investors use this form of entity in structuring their business arrangements.

As the following material will explore, the partnership entity creates a serious obstacle to deferring capital gain tax upon the disposition of appreciated real property for which creative workarounds have been developed to take advantage of one of the last great planning tools still available under the Code. In the immortal words of President John F. Kennedy:

The tax on capital gains directly affects investment decisions, the mobility and flow of risk capital…the ease or difficulty experienced by new ventures in obtaining capital, and thereby the strength and potential for growth in the economy. 18

II. SECTION 1031 OF THE INTERNAL REVENUE CODE AND PARTNERSHIP INTERESTS

A. Introduction

Code Section 1031(a)(1) provides that no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for

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investment if the property is exchanged solely for property of like kind19 that is to be held either for productive use in a trade or business or for investment. “Tax-deferred exchanges” were first recognized in the Internal Revenue Code of 1921 to allow simultaneous land swaps among farmers, and the current law for “Section 1031 exchanges” and the concept of “like-kind” property exchanges was memorialized in an amendment to the Internal Revenue Code of 1954. In 1984, the Tax Reform Act20 formally sanctioned the delay between the disposition of relinquished property and the acquisition of replacement property and also imposed the 45-day identification period and the 180-day exchange period. Then, the Tax Reform Act of 1986 restricted some of the tax benefits for investors in real property, and enactment of regulations governing Code Section 1031 in 1991 created strictly construed rules governing exchanges.21

Treasury Regulation Section 1.1031(k)-1(a) defines a deferred exchange as an exchange in which, pursuant to an agreement, the taxpayer transfers relinquished property and subsequently receives replacement property. 22 The transaction must fairly be characterized as an exchange and not a sale (i.e., a transfer of property for property, as distinguished from a transfer of property for money). The property exchanged (the “relinquished property”) and the property acquired (the “replacement property”) must each be “held for” trade, business or investment purposes only,23 and “dealers” cannot take advantage of tax-deferred exchanges because they are considered to be in the business of purchase and sale rather than investment.24 The taxpayer must hold property for investment or for income production, or intend to use the property in her trade or business, to satisfy the “qualified use” standard.

Code Section 1031 provides an exception to the general rule that gain or loss realized25 on the sale or other disposition of property must be recognized for federal tax purposes. It provides that neither gain nor loss is recognized if property held for investment or for productive use in trade or business is exchanged for like-kind property held for investment, trade or business. The “1031 Exchange”26 is a tax-deferral mechanism, not a tax-avoidance transaction: it provides an exception only from current recognition of realized gain. Accordingly, Code Section 1031, like all exceptions to the general recognition rule of Code Section 1001(c), is to be strictly construed and does not extend beyond the words or the underlying assumptions and purposes of the exception.27

The purpose of Code Section 1031 is to defer the recognition of gain or loss on transactions in which, although in theory the taxpayer may have realized a gain or loss, her economic situation is in substance the same after the transaction as it was before the transaction. Stated another way, if the taxpayer's money continues to be invested in the same kind of property, gain or loss should not be recognized.28

Code Section 1031 permits taxpayers to exchange “like-kind” properties, rather than sell them outright. No gain or loss is recognized on the exchange, so the payment of taxes on any gain is deferred until some future date. The theory behind deferral of gain under Code Section 1031 is that the taxpayer has not really changed position, since the new property is simply a continuation of the

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investment in the former property. The tax basis of the relinquished property is transferred to the replacement property.

Without Code Section 1031, a taxpayer would have to pay tax on a “paper gain”29 without actually receiving the cash to pay the tax. The increased wealth (“the gain”) is still tied up in a continuing investment in the same type of asset (“like-kind property”). Where the exchange reflects both continuity of ownership and investment intent, nonrecognition treatment will be afforded the transaction.30

Accordingly, property held primarily for sale is excluded from nonrecognition treatment.31 Typically, eligible assets are used in the taxpayer’s trade or business and held for more than one year at the time of disposition. These Code Section 1231 assets include depreciable tangible and intangible personal property, and real property, whether or not depreciable. They include timber, certain livestock and un-harvested crops that are transferred with the land. They do not include inventory or property held primarily for sale to customers in the ordinary course of the taxpayer’s business.32

A tax-deferred exchange allows the taxpayer to build wealth through a reinvestment of profits and appreciation in market value. At the same time, the taxpayer avoids having the current payment of taxes erode her wealth. Instead of using current dollars to pay taxes, the money is retained by the taxpayer and used for investment purposes.33 With the federal top marginal tax rate on long-term capital gains in the United States being 20 percent, plus the 3.8 percent tax on net investment income to fund the Affordable Care Act,34 U.S. taxpayers with an adjusted gross income of $400,000 ($450,000 married filing jointly) are subject to a capital gain tax of 23.8 percent.35 In addition, many states levy taxes on capital gains income, including Minnesota at a top rate of 9.85 percent.36 The average combined federal and state capital gains tax rate across the United States is now

28.6 percent.37

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Source: “The High Burden of State and Federal Capital Gains Tax Rates in the United States”, Tax Foundation, Fiscal Fact (Mar. 2015)

The attractiveness of the like-kind exchange cannot be underestimated for tax planning, because most long-term capital gains are generally taxed at rates lower than those that apply to wage and interest income.38 Given the significant difference between the top marginal tax rate for individuals (39.6 percent) and the top rate for long-term capital gains (20 percent, plus the 3.8 percent Medicare surcharge) applicable to gains recognized on real property held for more than one year, owners of such property seek to treat their gain on the sale as a capital gain rather than ordinary income, but generally have an enormous incentive to exchange the real property to defer tax on the gain, even at this more favorable rate. In a recent study examining data from the Department of the Treasury for 2010, the Congressional Budget Office and the staff of the Joint Committee on Taxation, taxpayers reported about $394 Billion in short-term and long-term net capital gains with only about $55 Billion owed in federal income taxes on those gains.39 And, according to very recent study conducted by Ernst & Young, 30 percent of all like-kind exchange properties involve non-residential real property.40 Clearly, the like-kind exchange is alive and well.

Notably, the future of Code Section 1031 now seems relatively assured despite the cacophony of calls for its elimination a few years ago. The current administration is particularly upset with the stepped-up basis rules that would permit the gain from the sale of a capital asset to pass tax-free to heirs and without consequence to the original taxpayer who may have been exchanging appreciated real property for many years, thereby accumulating significant unrecognized gains. Under Code Section 1014, upon death all property in the decedent’s estate is entitled to a stepped-up basis for purpose of calculating the heirs’ capital gain upon a subsequent sale.41 Under this rule, property is valued as of the date of the

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decedent’s death for purposes of determining its basis, without regard to when the property was originally acquired or its original basis. This rule allows an heir to avoid tax liability for all appreciation in value achieved during a decedent’s lifetime. Moreover, property that a person acquires as the surviving tenant by the entireties or as a surviving joint tenant is considered property acquired from a decedent to the extent the property is includible in the decedent’s gross estate. The part of the property that is treated as acquired from the decedent receives a stepped-up basis. The reduction in basis for depreciation is required depreciation allowed to the surviving joint tenant owner, whose new basis is at issue.

A recent groundbreaking study of the U.S. commercial real estate market by professors at the University of Florida and Syracuse University debunks the administration’s theory.42 In analyzing 1.6 million real estate transactions over an 18-year period, this study finds that a majority of replacement properties are eventually sold in fully taxable transactions, thereby not taking advantage of a stepped-up basis at death, and taxes paid in a fully taxable sale after an exchange are approximately 19 percent higher than taxes paid in a fully taxable sale without a preceding exchange. The study concludes that the like-kind exchange rules have created a more dynamic real estate sector by encouraging investment and reinvestment activity and ultimately the U.S. Treasury gets its due.

B. Partnership Interests Are Expressly Excluded

In the Tax Reform Act of 1984, Congress excluded a number of financial interests from nonrecognition treatment under Code Section 1031 without regard to investment intent, including partnership interests.43 With the addition of section 1031(a)(2)(D), although a partnership or limited liability company taxed as a partnership can perform an exchange at the entity level,44 the exchange of an individual partnership interest or LLC membership interest made on or after April 25, 1991 does not receive nonrecognition treatment.45 In short, the exchange of a partnership interest in one partnership for the partnership interest of a different partnership is not afforded nonrecognition treatment. The nonrecognition treatment of an exchange of interests in the same partnership is unaffected by the 1984 revisions to Code Section 1031.46

The exclusion of partnership interests under Code Section 1031(a)(2)(D) “encompasses all types of equity interests in financial enterprises other than by direct ownership of the underlying property.”47 Congress specifically excluded partnership interests because they were considered equivalent to stocks, bonds, or other “investment interests” which were already excluded from non-recognition treatment. Without this prohibition, Congress feared that taxpayers could escape the mandatory non-recognition treatment of Code Section 1031, by deferring gain on assets that have appreciated, but recognizing losses currently on assets that have lost their value. Congress also wanted to eliminate the abusive practice where taxpayers exchanged their interests in burned out tax shelter partnerships for interests in other partnerships without having to realize gains.48 To paraphrase

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the conclusion of one commentator, whatever happened to nonrecognition in partnership distributions?49

Because the taxable income of a partnership is computed in the same manner as for an individual, (subject to certain exceptions which are not pertinent to like-kind exchanges),50 partnerships will be entitled to nonrecognition treatment under Code Section 1031(a) when the partnership exchanges property held by it for investment for property of like-kind which is to be held by the partnership for investment. Just as the character of items of income taken into account by the respective partners is determined at the partnership level, the qualified use requirement is analyzed at the partnership level under Code Section 702(b), even when the partnership exchanges like-kind property subject to a liability in one taxable year and the replacement property, also subject to a liability, is received in the following taxable year.51 Even if a particular partner is a dealer in real property, neither the partnership nor such partner would be required to recognize income on a partnership level exchange if the partnership is not a dealer with respect to that property. The primary concern with respect to the sale of real property by a partnership is whether the sale is in the ordinary course of a trade or business.52

However, the Code denies the same right to individual partners. First articulated in Revenue Ruling 78-135, individual partners cannot exchange their respective partnership interests in two partnerships of which each is a partner. Any gain or loss realized by the partners on the exchange of their partnership interest does not

qualify for nonrecognition under Code Section 1031(a).

The general prohibition against the exchange of partnership interests should be an important consideration if certain partners or members want to dispose of their interests in the real estate in favor of other investments or simply to get away from partners they no longer like while other members want to remain invested in

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the same appreciated real estate. And yet, the business justifications for forming as a team noted earlier are big drivers to do business with others in the partnership form.

To later take advantage of a tax-deferred exchange of one’s interest in the partnership, a good deal of complicated planning is required. It is a recurring issue for trusted advisors, because it is exceedingly common that when a partnership sells its real property one or more of the partners wish to “cash” out while one more of the partners want to continue the investment in a tax-deferred exchange into replacement property. Let’s return to our example above involving the two-member LLC (taxed as a partnership) where the appreciated value of the apartment building (its only asset) is $15 Million and each partner has a $4.5 million income tax basis in the LLC interest. Assume that one partner wants to “sell out” to invest the proceeds in a commercial office building of the same value in a single-member LLC. The departing partner simply cannot dispose of the LLC interest and invest the proceeds in the office building on a tax-deferred basis.

One solution to this quandary is to make a partnership election out of Subchapter K. An interest in a partnership that has made a valid election under Code Section 761(a), to be excluded from the application of subchapter K, is treated as an interest in each of the assets of the partnership and not as an interest in a partnership. If a partnership has made a valid election to be excluded from the application of partnership tax rules under Code Section 761, the interest held by the individual partner shall be treated as an interest in each of the assets of such partnership and not as an interest in the partnership itself. 53 This election is only available if the organization falls under one of the categories listed in the statute and if the income of the members of the organization is capable of being adequately determined without the computation of partnership taxable income.54

The relevant language in Code Section 1031(a)(2) states, “an interest in a partnership which has in effect a valid election under 761(a) to be excluded from the application of all of subchapter K shall be treated as an interest in each of the assets of such partnership and not as an interest in a partnership.” This provision could be viewed to allow co-owners (those holding title as tenants-in-common and not as partners in an entity) to hold title through a partnership entity but to have the benefits of “true co-ownership” for federal tax purposes. Private Letter Ruling 200937007 reflects the IRS’s imprimatur to such an election out from Subchapter K.55 There, the taxpayer intended to sell his 25 percent interest in a certain partnership to an unrelated party in return for periodic payments under a promissory note from the party, allowing the taxpayer to report the gain under the installment method of Code Section 453. Assuming that the partnership at issue was an unincorporated entity, the IRS stated that, for federal income tax purposes, the taxpayer’s sale of its 25 percent interest in the partnership would be treated as a sale of the taxpayer’s 25 percent interest in the commercial real estate building owned by the partnership. The IRS later revoked that letter ruling when the partnership at issue was in actuality a corporate entity in which the shareholders could not considered the co-owners of the property.56

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However, it is unclear that even a limited liability company or similar organization, the premise under which the IRS issued PLR 200937007, would be allowed to “elect out” of Subchapter K.57 In Field Service Advisory 1999-23017, the IRS states in part: “generally, the Service does not allow entities formed under a state’s partnership or limited partnership laws to elect out of Subchapter K.”58 Treasury Regulation Section 1.761-2(a)(2)(i) would appear to restrict the election to situations where the participants in the joint purchase, retention, sale or exchange of investment property “own the property as co-owners.” Accordingly, parties who expressly exchange partnership interests in an actual partnership proceed at their own risk. The infrequency in which a partnership makes this election makes a thorough discussion beyond the scope of this article, but real estate investors should consult their tax advisors regarding the section 761(a) election.

III. CREATIVE SOLUTIONS TO THE PARTNERSHIP ISSUE UNDER CODE SECTION 1031

Despite the restrictions imposed by the regulations governing like-kind exchanges on the interests of partners, two mechanisms—infrequently used because circumstances rarely align – have textual or interpretive support for the exchange of partnership interests. Two exceptions apply to this general rule: (1) A taxpayer acquires 100 percent of the interests of the partners in a partnership that holds real property, pursuant to Revenue Ruling 99-6, or (2) the taxpayer contributes qualifying property to a REIT pursuant to Code Section 721.

A. Revenue Ruling 99-6: Direct Exchange of Partnership Interests

Revenue Ruling 99-6 addresses issues related to the conversion of multi-member LLCs to a single-owner entity. The ruling covers the transaction from two approaches:59 one LLC member sells his or her full interest to another member of the LLC (Situation 1 in the ruling) or all members of the LLC sell their full interests to an unrelated third party (Situation 2 in the ruling). Revenue Ruling 99-6 assumes that the LLCs are taxed as partnerships for federal income tax purposes. While it creates several traps for the unwary that should be carefully analyzed by tax professionals,60 it does permit the direct exchange of partnership interests despite the general prohibition against such exchanges under Code Section 1031(a)(2)(D), provided the transaction is structured to assure continuation of the partnership.

Situation 1 considers a two-member partnership (Partnership AB) in which the partners are equal owners. Partner B purchases all of Partner A’s 50 percent interest in the partnership for cash. Partner A is considered to have sold its partnership interest to B for which gain or loss must be recognized. Partner B is considered as if Partnership AB distributed all of its assets equally to the partners in liquidation of the partnership followed by Partner B’s purchase from Partner A the assets to have been distributed to Partner A. Pursuant to Rev. Rul. 99-6, the partnership is considered to have terminated under Code Section 708(b)(1)(A)

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(because none of its partners are carrying on any part of its business as a partnership) and made a liquidating distribution of its real property assets to its partners, and Partner B is treated as having acquired such real property assets from Partner A. Since Partner B will acquire 100 percent of the partners’ interests in the partnership, Partner B is treated as having acquired the real property assets of the partnership rather than as having acquired partnership interests from the partner.

Because of this analysis, Partner B could sell relinquished property held in a different partnership and use the sales proceeds in a like-kind exchange involving the purchase of the assets distributed to Partner A as the replacement property. Here, Partner B holds multiple real properties in several partnerships and finds economic and/or practical advantages in selling one of them to acquire the 100 percent interest in Partnership AB. This technique can be used to consolidate holdings or to exit a partnership involving dysfunction provided the partnership continues because B is not treated as acquiring A’s partnership interest in the exchange. A form of the purchase and assignment agreement that effectuates such a transaction from a real world circumstance is included at the end of these materials.

Situation 2 considers a two-member partnership (Partnership CD) in which the partners are equal owners. Partners C and D sell all of their partnership interests to E, a third party purchaser, for cash. Partners C and D are considered to have sold their partnership interests to E in liquidation of Partnership CD for which gain or loss must be recognized by the partners. E is considered to have purchased the distributed assets directly from Partners C and D and could therefore effect a like-kind exchange involving the sale of relinquished property, the proceeds of which are used to acquire the assets of Partnership CD as the replacement property.

Private Letter Ruling 20080700561 illustrates the mechanism. There, the taxpayer is a limited partnership (Partnership A) that holds rental real property as the relinquished property. The taxpayer entered into a sale agreement with an unrelated party for the relinquished property and looked to exchange it for replacement property owned by an unrelated limited partnership (Partnership B) holding real property. The taxpayer will form a wholly-owned limited liability company by which to acquire 100 percent of the individual partners’ interests in Partnership B by entering into a purchase agreement with each of the partners. At

the closing

of the

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relinquished property, all proceeds held by the qualified intermediary will be distributed to these partners in return for which the partners will assign 100 percent of their interests in Partnership B to Partnership A and the LLC, who will become the new limited partner and general partner, respectively, of Partnership B. Partnership B will continue to operate as a state law partnership after closing.

Pursuant to Revenue Ruling 99-6, the partnership is considered to have terminated under Code Section 708(b)(1)(A) and made a liquidating distribution of its real property assets to its partners, and the taxpayer is treated as having acquired such real property assets from the partners. Since the taxpayer will acquire 100 percent of the partners’ interests in the partnership, the taxpayer is treated as having acquired the real property assets of the partnership rather than as having acquired partnership interests from the partners. Further, the IRS found that this transaction does not constitute the type of abuses by sellers of partnership interests that Congress sought to remedy in the Deficit Reduction Act of 1984.

The taxpayer’s formation of the LLC to serve as the general partner and the continued existence of the partnership owned by LLC and the taxpayer following the closing comply with the requirement that taxpayers hold both the relinquished property and the replacement property for productive use in a trade or business or for investment. Because the LLC is disregarded as an entity, the taxpayer would be treated as owning all of the interests in the partnership following the closing of this transaction, and continuity of the original investment is assured.

Private Letter Ruling 20090900862 applied similar reasoning to a reverse exchange.63 An EAT was permitted to acquire a 50 percent partnership interest as replacement property for the taxpayer’s exchange when the other 50 percent of the partnership was already owned by the taxpayer. The EAT acquired the partnership interest from a person unrelated to the taxpayer. Real property was the only asset of the partnership. The EAT was a partner in the partnership during the

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parking period, and then transferred the partnership interest as replacement property to taxpayer to complete the forward exchange. Although not explicitly stated, one may draw the permissible inference that under these facts the partnership interest held by the EAT qualifies as replacement property for the taxpayer.

A note of caution should be observed for any exchange relying upon Revenue Ruling 99-6. As discussed at some length at Endnote 23, the acquiring partner must be advised of the holding period issues attendant to an exchange in which the partner acquires the other partner’s interest. As noted in McCauslen v. Commissioner,64 the acquiring partner is not allowed to tack on to his holding period the time attributed to the original partnership’s ownership of the real property. There, McCauslen purchased his deceased partner’s share in a florist business organized as a two-member partnership under Ohio law. Pursuant to a written partnership agreement that contained a buy-sell provision, McCauslen purchased the interest of his partner but within 6 months of that purchase, sold a partnership asset which had previously been owned by the partnership for a period of longer than 6 months. McCauslen reported the sale as one of long-term capital gain, and the IRS objected. The Tax Court confirmed the IRS objection. In finding that McCauslen’s sale of the partnership asset was subject to short-term capital gain tax rates, the Tax Court ruled that the acquiring partner is not entitled to tack on the holding period of the partnership to the portion of the partnership assets he acquired from his deceased partner.65 McCauslen’s holding period in the assets began to run the day after the sale, because he acquired the assets by purchase and not by distribution.

B. Indirect Exchange of Partnership Interests under Code Section 721: The upREIT66

Under Treasury Regulation Section 1.708-1(b)(2), the contribution of property to a partnership does not constitute a sale or exchange. Accordingly, a partnership will never be terminated under Code Section 708, based on a sale or exchange within a 12-month period of 50 percent or more of the total interest in partnership capital or profits as a result of a partnership “expansion”. Likewise, the liquidation of a partnership interest is not a sale or exchange, and would have no effect on a Code Section 1031 transaction whether occurring before or after a partnership level like-kind property exchange.

The most typical transaction takes the form of transferring fee title to real property

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at the entity level to a subsidiary partnership of a REIT (Operating Partnership), in return for which the individual partners obtain operating units (OP Units) in the Operating Partnership that provide for cash distributions that are the same on a per unit basis as the REIT’s per share dividend on its common shares.67 By using the Operating Partnership to acquire income producing real properties, the REIT can structure property acquisitions in which the seller (Selling Partnership) is able to defer tax on the transfer and obtain units of limited partnership interest in the Operating Partnership that, in general, are economically fungible with the REIT’s common shares. This organizational format is known as the “umbrella partnership” or “upREIT” structure.68

Source: Lou Stanasolovich, “Understanding the Complexities of UPREITS and DOWNREITS”,Global Economic & Investment Analytics (April 2, 2012)69

Partners in partnerships holding income producing property are attracted to the up REIT because the OP Units they acquire can be redeemed at the holder’s option for cash equal to the current market value of the same number of the REIT’s common shares (Redemption Right).70 In lieu of paying cash for the redeemed OP Units, the REIT has the option to provide an equivalent number of its common shares. The OP Units do not carry any voting rights with respect to the REIT or the election of its board of directors.

One of the significant advantages of transferring property to a partnership owned by a REIT in exchange for OP Units is the ability to defer recognizing taxable gain on the transfer. Selling Partnerships and their partners (Selling Partners) generally will not recognize taxable gain at the time of the transfer unless cash is paid for the property. The Selling Partnership and the Selling Partners will not otherwise have to pay tax on the built-in gain71 in the property unless and until (i) the Operating Partnership sells the property in a taxable transaction, (ii) the OP Units are redeemed for cash or REIT common shares or the OP Units are otherwise sold in a taxable transaction, or (iii) in the case of Selling Partners with negative capital account balances who receive OP Units in a transaction in which the Operating Partnership assumes the Selling Partnership’s existing mortgage debt (Selling Partnership Mortgage Debt), the Selling Partnership Mortgage Debt is repaid. The REIT can acquire properties with consideration consisting of combination of (i) cash, (ii) assumption of Selling Partnership Mortgage Debt, and (iii) OP Units.

The tax consequences of transferring properties to the Operating Partnership are described below.72

1. All OP Units to Selling Partnership.

The Operating Partnership could (i) issue only OP Units to the Selling Partnership and (ii) assume the Selling Partnership Mortgage Debt. At a later time (e.g., after the Selling Partnership’s representations and warranties relating to the transfers have expired), the Selling Partnership would distribute the OP Units to its partners. Except as noted below in

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Part 3, the Selling Partners generally would not be subject to tax as a result of the transfer or the distribution of OP Units by the Selling Partnerships.

2. Cash and OP Units to Selling Partnership.

Alternatively, the Operating Partnership could (i) issue a combination of cash and OP Units to the Selling Partnership and (ii) assume the Selling Partnership Mortgage Debt. Immediately after the transfer, each Selling Partnership would distribute the cash to some of its partners (the “Cash-Out Partners”). Each Selling Partnership would distribute the OP Units to the remaining Selling Partners either at the same time as the cash distribution or at some later time.73 Selling Partners that received OP Units in an all-OP Units transaction or a cash-and-OP Units transaction are referred to as “Equity Partners.”

The transfer would be treated in part as a taxable sale and in part as a tax-free contribution of property to the Operating Partnership for federal income tax purposes. To avoid the allocation of some portion of the gain from the taxable sale to the Equity Partners, the Selling Partnership’s partnership agreement generally would be amended to add a special allocation of all taxable gain associated with the transfer to the Cash-Out Partners. However, it is not clear under the applicable federal income tax rules whether a special allocation of this sort will be respected. If it is not respected, a proportionate share of the taxable gain would be allocated to the Equity Partners. As a result, many transactions that involve both Equity Partners and Cash-Out Partners are structured either as (i) an acquisition of the partnership interests in the Selling Partnership, rather than as a direct property acquisition, or (ii) a merger of the Selling Partnership into the Operating Partnership. Acquiring partnership interests in the Selling Partnership avoids the need for a special allocation of the Selling Partnership’s taxable gain to the Cash-Out Partners and provides certainty as the Equity Partners’ tax consequences. Similar tax certainty can be obtained by structuring the transaction as a merger.

The federal income tax rules allow a merger in which cash and OP Units are provided to the Selling Partners to be treated as (i) a sale by the Cash-Out Partners of their partnership interests for cash to the Operating Partnership in a taxable transaction and (ii) a merger of the Selling Partnership into the Operating Partnership in which the Equity Partners receive tax-deferred treatment. As with a direct acquisition of partnership interests, a merger avoids the need for a special allocation of taxable gain to the Cash-Out Partners. A merger may be more attractive than a direct acquisition of partnership interests if there is a concern that some minority partners of the Selling Partnership may not consent to the transaction. Except as noted in the immediately preceding paragraph and below in Part 3, the Equity Partners should not incur current tax liabilities as a result of the transfer or the distribution of OP Units from the Selling Partnerships.

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When two partnerships are merged, the resulting entity will be considered a continuation of the partnership which contributed more than 50 percent of the fair market value of the combined assets (net of liabilities). A merger transaction in which the resulting partnership is considered to be a continuation of the original owner of the relinquished property should not affect a partnership level exchange conducted by that entity. In structuring partnership expansions, liquidations or merger transactions incident to a like-kind exchange under Code Section 1031, care must be taken to avoid the “disguised sales” rules in Treasury Regulation Section 1.707-3, noted in Part 3(ii).

3. Potential Gain Recognition by Equity Partners upon Property Transfer.

i. Negative Capital Accounts.

One or more of the Equity Partners generally will have negative capital account balances if the aggregate principal balance of the Selling Partnership Mortgage Debt exceeds the Selling Partnership’s adjusted basis in the property. If the Selling Partnership Mortgage Debt is repaid and no remedial action is taken, the Equity Partners with negative capital account balances will recognize taxable income equal to part or all of their respective negative capital account balances. Typical remedial actions offered by REITs include refinancing the Selling Partnership Mortgage Debt with new debt that is secured by a mortgage on the transferred property and/or allowing the Equity Partners to guarantee some portion of the Operating Partnership’s debt that is not secured by a mortgage on the transferred property.

ii. Disguised Sale.

A current tax liability could be triggered for the Equity Partners if the transfer is recharacterized as a disguised sale under Code Sections 752 and 707.74 A disguised sale would be presumed to occur if an Equity Partner receives a distribution of cash or property from the Operating Partnership within the two-year period following the transfer, other than normal distributions of operating cash flow. For example, the exercise of the Redemption Right within two years following the transfer could be recharacterized as a disguised sale. That disguised-sale presumption likely could be rebutted if the redeeming Equity Partner can demonstrate that it did not anticipate exercising the Redemption Right within the two-year period immediately following the transfer and that the decision to redeem resulted from a change in circumstances.

The risk of a disguised sale also could arise if the Selling Partnership Mortgage Debt does not fall into one of the following

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categories (for this purpose, treating any refinancing as a continuation of the original debt to the extent that the net proceeds of the refinancing are used to repay the original debt) (each, a Qualified Liability):

A liability that was incurred more than two years prior to the transfer and has encumbered the property throughout such two-year period;

A liability that has not been outstanding for more than two years before the transfer, but that was incurred to purchase, or is properly allocable to capital expenditures with respect to, the property; or

A trade payable or other liability that was incurred in the ordinary course of the trade or business in which the property was used (regardless of how long such liability has been outstanding).

For example, disguised sale risk would be present if, within the two-year period preceding the transfer, the Selling Partnership incurred a liability and distributed part or all of the proceeds of that liability to its partners.75

4. Ultimate Gain Recognition by Equity Partners.

i. Sale or Redemption of OP Units.

Both the sale of the OP Units and the disposition of OP Units pursuant to the exercise of the Redemption Right should be treated as fully taxable transactions in which the holder of the OP Units will recognize gain or loss based on the difference between the amount realized on the disposition and the holder’s adjusted basis in the Unit sold or disposed of.76 If the OP Units are redeemed, the holder of the OP Units will be treated as realizing for tax purposes an amount equal to the sum of the cash or the value of the REIT common shares received in connection with the redemption plus the amount of Operating Partnership liabilities allocable to the redeemed OP Units at the time of the redemption. If a holder of OP Units sells a Unit, the holder will be treated as realizing for tax purposes an amount equal to the sum of the cash and fair market value of other property received plus the amount of any Operating Partnership liabilities allocable to the OP Unit sold. To the extent that the amount realized from the sale of OP Units or the exercise of the Redemption Right exceeds the holder’s basis in the OP Unit disposed of, such holder will recognize gain.

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ii. Taxable Disposition of the Property.

If the Operating Partnership disposes of the property in a taxable transaction, the Equity Partners will be required to recognize their allocable share of the built-in gain with respect to the property. The Equity Partners will not have to recognize gain if the property is disposed of in a like-kind exchange or other tax-deferred transaction.

iii. Repayment of Property-Level or Guaranteed Debt.

As described in Part 3 above, the REIT and the Equity Partner may agree upon remedial actions to avoid triggering the Equity Partner’s negative capital account, including leaving the Selling Partnership Mortgage Debt in place, refinancing the Selling Partnership Mortgage Debt with new debt that is secured by a mortgage on the transferred property, and/or allowing the Equity Partners to guarantee some portion of the Operating Partnership’s debt that is not secured by a mortgage on the transferred property. If the debt involved in such remedial actions is repaid in part or in whole, recognition of part or all of the Equity Partner’s remaining negative capital account balance may be triggered.

C. Partnership Break Ups – Divorce Law for Partners

For partnerships holding real property assets are comprised of partners looking to go their separate ways, and the partners seek to effectuate like-kind exchanges of their interests in the partnership, the partners will be required to acquire separate individual replacement properties to qualify for like-kind treatment. Two approaches to the issue have developed: (A) for the partnership break up involving the relinquished property, a distribution of the partnership property to the partners, followed by partner level exchanges involving their respective interests (the “drop and swap”), or (B) for the partnership break up involving the replacement property, an exchange transaction at the partnership level, whereby the partnership property is disposed of by the partnership, in exchange for various replacement properties designated by the partners, with such replacement properties being distributed to the appropriate partners, in liquidation of their respective partnership interests (the “swap and drop”).

1. The “Drop and Swap”, or Co-Tenancy as a Solution

If the respective partners are to acquire separate individual replacement properties, the most common approach is to make a distribution of the partnership property to the partners, followed by partner level exchanges involving their respective interests. Referred to as the “drop and swap” and a commonly recommended approach by tax professional, this approach – in which the partnership distributes interests to the partners in

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the form of fee title percentage interests in the underlying real estate, who then exchange real estate for other like-kind property – has meet with mixed results.77 The “substance over form” doctrine can lead the IRS and the courts to conclude that a purported drop and swap was in effect a sale by the partnership, followed by one partner’s reinvestment of his share of the proceeds, and not an exchange by the partner.78

Importantly, the timing of a drop and swap in relation to the closing date of the sale of the underlying real estate is often under scrutiny. Partners rarely have the foresight or the motivation to make changes to the form of ownership until a sale opportunity emerges. The partners then scramble to arrange their affairs so that some partners may exchange while allowing others to cash out. Distributions to partners one day before closing on the sale of the real property have been denied nonrecognition treatment.79 In this context, the question arises of whether the “held for use in a trade or business or for investment” test of Code Section 1031 can be satisfied if the partners receive their undivided interests shortly before the sale. The level of risk increases dramatically if the partnership itself is the designated seller on the purchase/sale agreement or if the drop and swap occurs just hours or days before closing on the sale.80

The leading case is Magneson v. Commissioner.81 Magneson and his wife sold an apartment building, received a 10 percent undivided interest in commercial property as replacement property and contributed cash and their 10 percent interest to a newly formed limited partnership in exchange for a 10 percent general partner’s interest, all under a pre-arranged transaction under Code Section 721. The Tax Court allowed nonrecognition treatment of the transaction, noting that joint ownership and partnership ownership are “differences [that] are more formal than substantial.”82 The Ninth Circuit’s decision on appeal has the very narrow holding of finding nonrecognition treatment under these facts only when the taxpayer exchanges properties of like-kind with the intent of contributing the replacement property to a partnership for a general partnership interest. In affirming the result, the Ninth Circuit emphasized that the “critical attributes” of the taxpayer’s relationship to the property were those “relevant to holding the property for investment” and concluded that the Magnesons’ control of the property, as general partners, was of the same nature as their control as tenants-in-common, insofar as it related to holding the property for investment. The Ninth Circuit distinguished Revenue Ruling 75-292,83 which concerned a corporate transaction, by observing that that transaction, viewed as a whole, resulted in the exchange of property for stock, which was expressly excluded under Code Section 1031(a), while no such prohibition then existed on the exchange of partnership interests.

In Bolker v. Commissioner,84 the Tax Court considered whether Bolker met the “held for investment” standard where he acquired the property

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from his corporation under a pre-arranged plan to dispose of it in the exchange. The court followed its decision in Magneson in concluding that Bolker met the test, since he did not hold the relinquished property for sale, personal use or for transfer as a gift. Since the Tax Court did not consider that Bolker had “cashed in” on theoretical gain or “closed out” a losing venture, it allowed nonrecognition treatment.85 The Ninth Circuit86 upheld the Tax Court’s decision in Bolker but delineated the “held for investment” standard into two component parts: “. . . a taxpayer may satisfy the holding requirement by owning the property, and the for productive use in trade or business or for investment requirement by lack of intent either to liquidate the investment or to use it for personal pursuits.” 87 The Ninth Circuit held in Bolker that the intent to exchange property for like-kind property satisfies the holding requirement, since it is “not an intent to liquidate the investment or to use it for personal pursuits”, and stated that the commissioner’s position, in effect, would result in an additional requirement unexpressed in the statute “to keep the first piece of property indefinitely”.

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Magneson represents the IRS’s unsuccessful effort to extend Revenue Ruling 75-29288 to the partnership context under the law in effect prior to the 1984 enactment of Code Section 1031(a)(2)(D).89 In light of the specific circumstances found in Magneson, the different legal analysis applied by the Tax Court and by the Ninth Circuit in upholding the original decision, and in recognition that the enactment of section 1031(a)(2)(D) might compel a different result, there is legitimate uncertainty about the current implications of the taxpayer’s victory in Magneson. In fact, the California Franchise Tax Board of Equalization successfully challenged a “swap and drop” on the grounds that Magneson was effectively overturned by the 1984 amendment to Code Section 1031, denying nonrecognition treatment to the taxpayers in that case.90 The Oregon Tax Court has rejected this argument, finding in favor of the taxpayer.91 Recently, in an apparent rejection of its previous position, the California Board of Equalization issued a formal opinion concluding that a “swap and drop” transaction qualified for nonrecognition treatment where two partners exchanged their separate properties for TIC interests in a shopping center on June 30, 2003 that served as their replacement property (the swap) and, seven months later on January 23, 2004, contributed their respective TIC interests into a partnership (the drop).92

Of course, the Tax Court may simply ignore the “drop.” In Chase v. Commissioner,93 the court applied the “substance over form” doctrine in concluding that a purported “drop and swap” transaction was in effect a sale by the partnership, followed by one partner’s reinvestment of his share of the proceeds, and not an exchange by the partner. In this case, Chase created a California limited partnership, John Muir Investors (JMI), for purposes of acquiring and operating an apartment building in San Francisco. After holding the apartment building for about a year, a “condo conversion” craze beset San Francisco by which apartment buildings would be converted to condominium units for sale to individuals, fetching a premium for the owners of such buildings. After JMI accepted an offer to sell its apartment building, Chase caused the partnership to execute a deed covering an undivided interest in the property to himself and to his wife, but did not record the deed until he was certain that the sale was going to close. The escrow instructions for the closing did not mention his individual interest, Chase did not bear any property expenses, or receive any rental income, in his individual capacity, during the period of his purported ownership, no approval or modification was sought or obtained from the other partners under applicable provisions of the partnership agreement and in general “petitioners’ relationship with respect to the apartments, after they were deeded an undivided interest in such, was in all respects unchanged in relation to their relationship to the apartments as limited partners of JMI.” 94

In summary, the partnership can distribute the interests to the partners as tenants-in-common prior to the exchange, then have partners exchange

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those interests. Deeds should be recorded. Negotiations for the sale of the property, and all other related activity, should be done in the names of the individual partners. Partners who want cash can sell their undivided interests to the buyer. The other partners can exchange their undivided interests in the relinquished property for the replacement property. This plan was approved in Bolker v. Commissioner.95 However, advance planning is required, as the IRS disallowed an exchange where the interest in real estate was distributed to the individual partner one day prior to the closing on the relinquished property.96 And be sure to avoid the obvious manipulations of the taxpayer in Crenshaw v. Commissioner.97 There, the taxpayer’s “drop and swap” was also not sanctioned by the court. The taxpayer liquidated her investment in a partnership and received an undivided interest in the partnership’s primary asset (an apartment building). She then exchanged this interest for a shopping center held in her husband’s estate. The estate sold the interest in the apartment building to a corporation owned by her former partners. The Fifth Circuit understandably held that the taxpayer was not entitled to nonrecognition treatment because all of the steps were engaged in to avoid the taxable sale of her partnership interest to her former partners.

The IRS approval of any “drop and swap” transaction finds an additional obstacle in the co-tenancy form of ownership.98 Once the partnership interests are redeemed in return for undivided real property interests, the former partners activities in holding and managing the real property as individuals constitute a “deemed” partnership under Code Section 761, particularly if there is a significant level of activity involved in the operation and management. In many respects, the line between co-owners (evincing a sense of disinterestedness toward other co-owners) and partners (evincing a sense of cooperation and desire for mutual success for all partners) is indeed a very thin one, allowing the IRS to find a partnership regardless of how title is held, i.e., title may be held as tenants-in-common but the activities of the parties (carrying on a business) may constitute a partnership. The IRS definition of “partnership” excludes “mere co-ownership of property that is maintained, kept in repair and rented or leased by the co-owners,” so the co-owners must limit their management activities to “customary tenant services” (e.g., water, heat, trash removal, routine maintenance) and avoid providing extraordinary services (e.g., concierge services, attendant parking, etc.).99 If the co-tenants are treated as separate owners, for federal tax purposes, and not as a deemed partnership, then each co-tenant will be permitted to engage in their own separate exchange transactions. Generally, the distinction between “mere co-ownership” and a deemed partnership will turn on the intent of the parties and on the extent to which they “actively” conduct a joint business.100

The parties must be careful not to go beyond these parameters to avoid being characterized as actively carrying on a business and cannot have a

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formal written agreement governing their conduct that can be viewed as nothing more than a partnership agreement. In one case, two brothers each owned a 50 percent interest in real estate, as tenants in common.101 The brothers considered themselves to be mere “co-owners”, and attempted to exchange into separate properties. They did not have a partnership agreement, but they had filed partnership tax returns for the five years prior to the exchange. Not surprisingly, the IRS found that they were a partnership, and disallowed the exchange.102 The taxpayers’ actions created a “deemed” partnership, despite the fact that record title was held in the taxpayers’ individual names.

2. The “Swap and Drop”

The “swap and drop” approach to partnership break ups have the partnership conduct the exchange transaction at the partnership level, whereby the partnership property is disposed of by the partnership, in exchange for various replacement properties designated by the partners, and those replacement properties are then distributed to the appropriate partners, in liquidation of their respective partnership interests. This alternative is rarely pursued because the partners have exigent circumstances requiring a more immediate solution than to remain partners as they work through the timing and challenges of the swap and drop. Nonetheless, the approach has been vindicated as complying with the exchange rules in Maloney v. Commissioner.103

Partnership completes like-kind exchange (the “swap)

By distributing out multiple replacement properties to the partners in liquidation of the partnership (the “drop”)

Maloney involved an exchange by a corporation that exchanged real property (the “I-10” property for “Elysian Fields”) followed by a liquidating distribution of all corporate assets, including the replacement property (Elysian Fields) to its shareholders, who thereafter leased it to other corporations they owned, under former Code Section 333. The Tax Court held that Code Section 1031 applied to the transaction finding that the corporate liquidation disrupted neither "continuity of ownership" nor continuity of "investment intent." The court concluded that the petitioners “did not intend to cash out their investment in the property received,” noted that the taxpayer’s “economic situation is in substance the same”

PARTNERSHIP RELINQUISHED PROPERTY

PARTNER 1 REPLACEMENT PROPERTY

PARTNER 2 REPLACEMENT PROPERTY

PARTNER 3 REPLACEMENT PROPERTY

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before and after the transaction and followed both Bolker and Magneson in allowing nonrecognition treatment since “petitioners continued to have an economic interest in essentially the same investment, although there was a change in the form of ownership.”104

The “swap and drop” approach to partnership break ups also finds support in Mason v. Commissioner.105 At issue were partnerships involving Mason, a wealthy investor, and McClure, an individual who managed Mason’s investments. Various real properties owned by two separate partnerships were exchanged by the partners, so that each took title to certain assets in his individual name as a result of the partnership break up pursuant to a single sales contract and a simultaneous closing. The IRS objected to the taxpayers’ claim of like-kind exchange treatment, arguing that Mason and McClure exchanged partnership interests, and not real property owned by them individually following liquidated distributions from the partnerships. Because their agreement referred to an exchange of “certain tracts of real property”, the Tax Court concluded that the partnerships terminated prior to the partner-level exchanges. While Mason allowed nonrecognition treatment of these transactions as like-kind exchanges, the court did not discuss whether Mason or McClure met the “held for investment” and the IRS did not challenge the taxpayer on this ground.

The lesson to be gleaned from Maloney and Mason is to structure the partnership level exchange so that distributions of replacement properties to individual partners takes place as long as possible after the exchange, to help the partnership meet the “holding” requirements of Code Section 1031 and avoid the step transaction doctrine. The interests may be distributed as like-kind property or as cash, depending on the needs of the partners, but for those seeking nonrecognition treatment, the receipt of replacement property should be delayed as long as possible.

While the cases which discuss the applicability of the substance over form analysis to exchange transactions generally deal with the “drop and swap” format, such an analysis can also be applied where an exchange at the partnership level results in relinquished properties selected by the respective partners which are then distributed to them. In this case, the issue would be whether the partnership acquired the respective replacement properties if the individual partners were the real parties actually involved in the negotiations to acquire those properties and the properties were deeded directly to the individual partners by the sellers. If it could be considered that the partnership disposed of the relinquished property, but the individual partners in substance acquired the replacement properties, using the partnership as a “mere conduit” to effect those purchases, then the exchange could be attacked under the analysis of Technical Advice Memorandum 9818003,106 in which the taxpayer unsuccessfully argued that the direct deeding of the replacement properties

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to partners of the taxpayer does not affect the status of the transaction as an exchange by taxpayer. This TAM rejects the proposition that the “partners, as recipients of the replacement properties, stand in the same relative position” in the transaction as the partnership itself.

In analyzing this very fact pattern but on other grounds, the Chief Counsel Office has opined that nonrecognition and substituted basis rules of Code Sections 731 and 732 did not apply to a transaction in which the partnership acquired replacement property that had no relationship to the partnership’s business activities solely for purposes of immediately distributing the real estate to a partner in liquidation. In Chief Counsel Advisory 200650014107, a partnership owned a large parcel of real property that, following ongoing disagreements among the partners, most of the exiting partners, including the taxpayer, liquidated their partnership interests. The liquidation of the taxpayer’s partnership interest was outlined in a redemption agreement providing for the purchase and distribution in redemption of a single-family home to taxpayer. The partnership formed an LLC that acquired the house in one tax year that was, pursuant to the redemption agreement, transferred to taxpayer in year two in redemption of taxpayer’s partnership interest. In denying nonrecognition of the redemption, the Chief Counsel highlighted the fact that the replacement property was selected by the partner, acquired by the partnership immediately before the distribution of the property in redemption of the taxpayer’s interest in the partnership and was entirely unrelated to the partnership’s business activities. Under these facts, the transaction was recharacterized as one in which the house was acquired and held for the account of the taxpayer and became the property of the taxpayer at the time it was acquired for taxpayer by the partnership, finding that the partnership’s acquisition of the house was in effect a cash distribution to taxpayer and not a purported distribution of the real property to the taxpayer.108

This analysis is ultimately premised on the ability to contribute and distribute appreciated properties to and from partnerships, without gain recognition, outside of Code Section 1031 which is referred to as a “mixing bowl” transaction under Code Section 737.109 In such a transaction, each partner contributes an appreciated property to a partnership, and subsequently receives the other property in a liquidating distribution, without tax consequence. Potential abuses led to the enactment of Code Sections 704(c)(1)(B) and 737. Generally, a seven-year holding period is now required before the contributed partners can receive a property contributed by someone else without recognizing gain.110 However, under Code Section 704(c)(2), property contributed by a partner may be distributed by the partnership to another partner if the contributing partner receives a distribution of property of a like-kind to his contributed property not later than the earlier of the 180th day after the distribution of

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his contributed property or the due date (determined with regard to extensions) for the contributing partner’s tax return.111

The partnership can make the exchange at the partnership level, then make distributions of interests in the replacement property to the partners sometime thereafter. This transaction should be effected as long as possible after the exchange, to help the partnership meet the “holding” requirements of Code Section 1031 and avoid the step transaction doctrine. The interests may be distributed as like-kind property or as cash, depending on the needs of the partners. This plan was approved in Maloney v. Commissioner.112 If the assets of the partnership are large enough, the partnership could acquire multiple replacement properties, then distribute those properties to the partners. Beware, however, of the successful challenge of a “swap and drop” on the grounds that Magneson was effectively overturned by the 1984 amendment to Code Section 1031, denying nonrecognition treatment to the taxpayers in that case.113 In the words of one leading commentator on the subject, “Can You Relax If the Police Aren’t Looking for You?”114

The anti-mixing bowl rules apply to property contributed to a partnership. Accordingly, the rules would not on their face apply when the partnership purchases property. It may be possible to accomplish something analogous to an exchange/partnership split-up by having the partnership acquire property by purchase, and then distribute that property to one partner in liquidation of his partnership interest. However, the weight of authority suggests that, if the selling/liquidating partner selects the property and arranges the terms and conditions for its purchase, with the partnership never bearing any significant “benefits and burdens” of ownership, then the selling/liquidating partner may be considered to have received cash, in a taxable transaction, followed by reinvestment of that cash, through the purchase of his property, in a separate transaction.115

3. A Common Challenge to Either Form of Partnership Breakup – Same Taxpayer Rule

The IRS has not acquiesced in these court holdings and, as noted above, the leading case of Magnuson is subject to attack as being inapposite given the 1984 amendments to the Code. While the Tax Court and the Ninth Circuit have ruled in favor taxpayers, the IRS continues to challenge these transactions and recently amended Form 1065, Schedule B, to ferret out these partnership breakups effective for returns filed after December 12, 2008, questions in Schedule B are modified to read:

13: Check this box if, during the current or prior tax year, the partnership distributed any property received in a like kind exchange or contributed such property to another entity (including a disregarded entity).

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14: At any time during the taxpayer year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property?

Whether the transaction is accomplished by a “drop and swap” or a “swap and drop” exchange, the IRS may question who actually effected the exchange. The concern is a very real one because of the “same taxpayer” requirement that, while not explicitly stated in Code Section 1031, it is a legal requirement derived from Code Section 1031(a)(3) and applies to individuals, partnerships, corporations and some trusts. Generally, an individual taxpayer must acquire the replacement property but may do so in a single member limited liability company in which the taxpayer is the sole member.116 If the individual taxpayer dies during the exchange period, the exchange may be completed by the deceased’s estate.117 If the relinquished property was held either as community or separate property among married persons residing in a community property state, the replacement property should be held as community or separate property.118 The same partnership which sells relinquished property must acquire replacement property,119 but conversion from a general partnership to a limited partnership or limited liability company during the exchange period should not violate the rule.120 A change in ownership among the partners of the partnership may occur during the exchange period so long as the partnership does not terminate as a result, although the IRS has not offered guidance on Code Section 708(b)(1) terminations; provided, however, partners in a partnership cannot complete an exchange initiated by the partnership at the entity level. Finally, a corporation that owns relinquished property must also acquire the replacement property and not its shareholder(s). However, if a corporation undergoes a tax-free reorganization during the exchange period, its successor may acquire the replacement property.121

These considerations give the IRS an opening to object to nonrecognition treatment if, all things being equal, the form of the taxpayer has changed during the exchange period. The leading case is Commissioner v. Court Holding Co.122 There, a closely-held corporation with husband and wife shareholders reached an oral agreement to sell its apartment property. After the shareholders were advised of the tax consequences, they attempted to “call off” the sale by the corporation, declared a liquidating dividend, entered into a sale contract individually, as sellers of the distributed property, on substantially the same terms and conditions as previously agreed upon, and attempted to treat the shareholder’s sale as unrelated to the prior negotiations. The Tax Court made a finding that the whole transaction showed a sale by the corporation, rather than by the shareholders, subjecting the sale to capital gains tax.

However, Court Holding Co. does not give carte blanch approval to all sales of corporate property by the shareholders shortly after liquidation

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and distribution in kind.123 In fact, the Tax Court has the inherent authority to look beyond the transactional documents between the corporation and its shareholder to determine whether the sale had actually been made by the corporation.124 Its opinion in Bolker extensively analyzed the factual setting to determine whether the exchange in question was made by Crosby Estates, Inc., or its sole shareholder, Bolker, who received Crosby’s assets in a liquidating distribution prior to the exchange. The Tax Court held that in substance as well as form the exchange was made by Bolker, individually. While the IRS appealed portions of the Tax Court decision, it did not appeal this particular determination.

In United States v. Cumberland Public Service Co.125 the shareholders, concerned that their power company providing diesel generated electricity to about 800 farmers would be forced out of business because of an inability to compete with the newly-formed Tennessee Valley Authority, created by congressional charter to provide navigation, flood control and, among other things, electricity generation to the Tennessee Valley, a region made destitute by the Great Depression. The shareholders offered to sell all of their corporate stock to a competing cooperative. The cooperative declined to buy the stock and countered with an offer to buy real property and improvements from the corporation. The corporation rejected the counter-offer based on a capital gains tax consequence of roughly $17,000. The shareholders then made an offer to the cooperative to acquire the equipment, in a corporate liquidation, and sell it to the cooperative. This offer was accepted and consummated by the parties.

The Supreme Court noted that the distinction between a corporate sale and a distribution followed by shareholder sales may be “particularly shadowy and artificial” when the corporation is closely held.126 However, its opinion upheld the trial court’s determination that the sale was effected by the stockholders, and that the corporation did not at any time plan to make the sale itself. The Supreme Court stated that it defers to the fact finding tribunals in tax cases and that such tribunals are free “to consider motives, intent, and conduct in addition to what appears in written instruments used by parties to control rights as among themselves.”127

Accordingly, the Tax Court indicated in Merkra Holding Co., Inc. v. Commissioner128 that a negotiated sale will be attributed to the corporation, and not to its shareholders, in most cases, only if the negotiations through the corporation have “culminated” in an agreement or understanding such that the later transfer by the shareholders was actually “pursuant to the earlier bargain struck.” Of concern in all these cases involving the sale of corporate property by the shareholders shortly after liquidation and distribution in kind is the “particularly shadowy and artificial” nature when the corporation is closely held.129 The IRS may continue to argue that this particular form of transaction cannot be property attributed to the corporation.

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D. Exchange for Property, Plus Installment Note.130

As discussed above, a number of technical and practical concerns arise when a partnership attempts a break-up using either the “drop and swap” or “swap and drop” transaction. One alternative approach for the partnership break-up involves the partnership’s conveyance of relinquished property for replacement property, plus the buyer’s installment note, or, according to one noted commentator, the “Partnership Installment Note Solution” or “PIN”.131 The “cash-out” partners then receive the installment note in liquidation of their partnership interests while allowing the partnership to avoid recognizing gain on the sale of the relinquished property, as the distribution of the installment note will not result in the recognition of income to the partnership or the exiting partners under Code Section 453(b). 132 The partnership specially allocates the taxable boot gain solely to the exiting partners. The installment sale rules of Code Section 453 allow a seller who sells appreciated property on an installment basis to defer paying capital gain taxes to future tax years when installment payments are actually received. This strategy allows the deferral of gain recognition to later years for those partners disinterested in carrying on the business of the partnership with tax due by them only in proportion to payments received from the buyer in those years.

At closing, the buyer gives a note, which calls for 99 percent of the note amount to be paid in 30 Days, with the balance paid at the start of the next tax year. The note is distributed to the “cashing out” partner to redeem the partnership interest. The partnership does not recognize gain or loss on the receipt/distribution of note.133 The cash out partner recognizes gain as payments are received under the installment method. To avoid taxation of the note at the partnership level, under the step transaction doctrine, it would be best to wait some period of time after the sale, before the installment note is distributed to the exiting partners. To qualify for installment treatment, the note must provide for at least one payment in the following tax year. Any mortgage boot recognized in the partnership’s acquisition of the replacement property must be entirely replaced by the continuing partners and depreciation recapture will apply to all prior depreciation up to the amount of the note. Therefore, while the PIN approach appears to have fewer challenges to it, the partners’ economics may not allow for this approach.

E. Special Allocations – The Arranged Marriage

In those limited cases where the parties are willing to remain as partners, the partnership could provide for special allocations under which significant benefits and burdens of individual partnership properties are specially allocated to the respective partners. Instead of a “drop and swap,” the partnership could acquire two separate replacement properties and then allocate income and expense from the first property to Partner 1 and from the second property to Partner 2. A partnership allocation is simply a division of each item of income, gain, loss, deduction and credit of the partnership between the partners, but to be respected, the allocations must have substantial economic effect. If all of the other

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provisions of the Treasury Regulations governing Code Section 704 are satisfied, such allocations would probably have substantial economic effect.134

To have substantial economic effect, allocations must have "economic effect" and that economic effect must be "substantial."135 To have "economic effect" under the primary economic effect test, (i) the partnership making the allocations must maintain capital accounts according to the provisions in the Treasury Regulations; (ii) the partnership must liquidate according to those capital accounts; and (iii) if a partner has a deficit capital account balance upon liquidation, the partner must be obligated to restore its deficit balance or the partnership must satisfy an alternate test described in the regulations.136 This economic effect test is designed to result in tax allocations that are consistent with the underlying economic arrangement of the partners.

Example 10 under Treasury Regulation Section 1.704-1(b)(5) involved a travel agency formed by S&T as a general partnership. The partnership agreement provided that T, a resident of a foreign country, was to be allocated 90 percent, and S 10 percent, of income derived from operations conducted within that country, while all remaining income was to be allocated equally between S&T. The example concludes that the allocations have substantial economic effect, since the amount of separately allocated income could not, under the circumstances, be predicted with any reasonable certainty. However, if 100 percent of the benefits and burdens of a replacement property were allocated to a particular partner, such allocation could be considered tantamount to a distribution of that property to the partner. In that circumstance, the transaction would probably be recharacterized as a “swap and drop” and be scrutinized accordingly.

Special allocations have limited utility in more recent real estate partnerships because most partnership agreements now contain targeted allocations and not safe-harbor allocations. Under this newer approach, a partnership liquidates not in accordance with partner capital accounts but, instead, in accordance with a negotiated distribution waterfall that reflects exactly the partners’ economic deal. It is the order in which any cash available for distribution will be allocated to the partners, and these partnership agreements require that taxable income or loss be allocated in the same manner as Code Section 704(b) book income or loss. The safe harbors only apply to special allocations tied to partners’ capital accounts based on book income or loss, not taxable income or loss. Code Section 704(b) was intended to prevent partners from allocating partnership items based on purely tax rather than economic consequences. To the extent allocations are made to realize tax advantages irrespective of the economic reality among partners, the IRS will find them lacking in substantial economic effect and disallow them.

IV. CONCLUSION

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Partnerships present very real challenges when exiting partners want to discontinue the business of the partnership but take advantage of favorable capital gain tax treatment upon their disposition of their partnership interests under Code Section 1031.

Ongoing concerns about the most prevalent forms of partnership “break-up” discussed above – the “drop and swap” and the “swap and drop” – create continuing and unresolved issues. According to the American Bar Association, the IRS should clarify the legal standards to be applied when:

(i) A relinquished property was formerly held by a partnership and distributed to one or more partners in anticipation of an exchange;

(ii) A relinquished property is held by a partnership and only some of the partners desire to participate (indirectly) in the exchange; and

(iii) A replacement property in an exchange is transferred to a partnership.137

Additionally, while these key weapons in the IRS arsenal have general applicability to nearly all tax-advantaged arrangements, the step transaction and economic substance doctrines plague Code Section 1031 planning. Of most significant concern is the step transaction doctrine, in which the IRS can hold that a series of transactions will be integrated if there is an intention to undertake each supposedly separate transaction in order to achieve a specific end result. In other words, the separate transactions may pass muster individually, but taken together they result in a transaction that is not permitted. In an exchange scenario, certain transactions may occur prior to or after the exchange such that the IRS may characterize each of the transactions as merely steps in a larger transaction and thus disqualify the exchange. Only careful, advanced planning can assure a successful partnership break-up.

1 This discussion is designed to identify the problem and the leading solutions but by no means is exhaustive. The views expressed herein reflect the author’s expressions and are not necessarily those of Cozen O’Connor. Before using any information contained in these materials, a taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor. Tax advisors should research these issues independently rather than rely on these materials. CIRCULAR 230 DISCLOSURE: TO ENSURE COMPLIANCE WITH REQUIREMENTS IMPOSED BY THE INTERNAL REVENUE SERVICE, WE INFORM YOU THAT (A) ANY UNITED STATES FEDERAL TAX ADVICE CONTAINED HEREIN WAS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED, FOR THE PURPOSE OF AVOIDING UNITED STATES FEDERAL TAX PENALTIES, (B) ANY SUCH ADVICE WAS WRITTEN TO SUPPORT THE PROMOTION OR MARKETING OF THE TRANSACTION OR MATTER ADDRESSED HEREIN AND (C) ANY TAXPAYER TO WHOM THE TRANSACTIONS OR MATTERS ARE BEING PROMOTED, MARKETED OR RECOMMENDED SHOULD SEEK ADVICE BASED ON ITS PARTICULAR CIRCUMSTANCES FROM AN INDEPENDENT TAX ADVISOR. The author gratefully acknowledges the assistance of James Minor with editorial assistance. James is an associate in the firm's Minneapolis office and earned his J.D. from the University of Minnesota Law School. Prior to attending law school, James was a sniper team leader in the U.S. Army's 2/75th Ranger Regiment. Any typographical and grammatical errors, and citations failing to meet blue book standards, are the sole responsibility of the author and not Mr. Minor. 2 According to Forbes, REIT stocks climbed to the top of the performance leaderboard in the fourth quarter of 2015. Ky Trang Ho, Why 2016 Should Be An Awesome Year To Invest In REITs, Forbes (Dec. 18, 2015, 10:01 AM), available at: http://www.forbes.com/sites/trangho/2015/12/18/why-2016-should-be-an-awesome-year-to-invest-in-reits/#113abb172d66. 3 The author acknowledges reliance on Mertens Law of Federal Income Taxation (1997-2016) to backstop his understanding of the matters presented in this section.

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4 All references to the Internal Revenue Code are to the 1986 Internal Revenue Code, as amended, or Treasury Regulations promulgated there under. 5 Under the “check the box” rules, many business entities may elect to be taxed as a partnership (featuring pass-through taxation) or as a corporation (featuring double taxation) even if the entities do not possess many of the traditional characteristics of those entities. A perfect example of this option is the limited liability company that elects to be taxed as a C corporation. See Treas. Reg. §§ 1.7704-1 to 1.7704-3 for the “check the box” rules and Treas. Reg. § 1.7704-2 for the list of entities that cannot elect pass-through tax treatment and must be taxed as C corporations. For a business entity that does not have to choose to be taxed as a C corporation, see Treas. Reg. § 301.7701-3. I.R.S. Publication 541 is instructive. 6 A limited liability company is treated as a partnership for federal income tax purposes if it meets certain classification requirements, including the obvious that it has at least two members. If the LLC possesses no more than two characteristics of a corporation, the LLC will be classed as a partnership. If it has three or more, it will be treated as a corporation. The four characteristics are: continuity of life; free transferability of interests; centralization of management and limited liability. Although the Treasury Regulations make no specific mention of LLCs, an exchange involving an LLC with two or more members will typically be treated in the same manner as an exchange involving a partnership. See n. 4, supra, regarding the check the box rules. Limited liability companies (LLCs) are a creation of state law. LLCs are owned and in some cases managed by “members” who do not bear personal liability for the acts, debts or obligations of the LLC. The LLC may elect to be classified for tax purposes either as a partnership or as a corporation, assuming the LLC is not mandatorily classified as a corporation by the Treasury Regulations. If an LLC is characterized as a partnership for federal tax purposes, the LLC will offer its members the flow-through of tax attributes, along with limited personal liability. T.D 9356, 2007-2 C.B. 675, provides special guidance for single-member LLCs when an EIN is needed to report employment tax liabilities. 7 I.R.C. § 301.7701-3. 8 I.R.C. § 731(b). 9 8 MERTENS LAW OF FED. INCOME TAX’N §33.15. 10 Id. at §33.16. 11 11 MERTENS LAW OF FED. INCOME TAX’N §41B.4. 12 See generally I.R.C. § 1363 and I.R.C. § 1366 relating to S corporations and I.R.C. § 701 and I.R.C. § 702 relating to partnerships. 13 Self-employment tax is a tax consisting of Social Security taxes and Medicare surtaxes primarily for taxpayers who work for themselves. Under the Affordable Care Act, an additional Medicare surtax rate of 0.9 percent is imposed to wages and net investment income above the threshold amounts discussed there. See Section 1402(b)(1)(B) of the Health Care and Education Reconciliation Act of 2010, amending Code Section 3101(b) to impose this surtax on the earned and net investment income of high-income taxpayers above certain thresholds. “Materially participating” members of S corporations or LLCs taxed as S corporations may avoid all self-employment taxes on all pass-through income distributions. Hence, the attractiveness of this form of entity in many circumstances. Be cognizant of at least Radke v. U.S., 895 F. 2d 1196 (7th Cir. 1990), Joseph M. Grey Public Accountant, P.C. v. CIR, 199 T.C. 121 (2002) and David E. Watson, P.C. v. U.S., 668 F.3d 1008 (8th Cir. 2012)(in a matter of first impression, the Eighth Circuit held that the “reasonable compensation” analysis of the I.R.S. applies to FICA tax cases). 14 This is not to suggest that tax advisors are without tools in minimizing income tax liabilities for shareholders of S corporations, because (among other things) some distributions are not includible in income. In general, a shareholder's basis in the stock of an S corporation is increased by the shareholder's pro rata share of the corporation's income, decreased by the shareholder's pro rata share of the corporation's losses and deductions, and also decreased by the amounts of distributions not includable in income. See I.R.C. § 1367. I.R.C. § 1368(a) provides that a “distribution of property made by an S corporation with respect to its stock to which (but for this subsection) section 301(c) would apply shall be treated in the manner provided in subsection (b) or (c), whichever applies.” I.R.C. § 1368(c) generally provides that if such a distribution is made by an S corporation out of previously taxed undistributed earnings and profits, it shall not be included in income to the extent it does not exceed the adjusted basis of the stock. If the distribution is made by an S corporation which has no accumulated earnings and profits, pursuant I.R.C. § 1368(b), the distribution shall not be included in gross income to the extent that it does not exceed the adjusted basis of the stock, and the amount of the distribution which exceeds the adjusted basis of the stock shall be treated as gain from the sale or exchange of property. Of course, losses and deductions cannot exceed a shareholder’s basis in stock and the shareholder’s adjusted basis of any indebtedness of the S corporation to the shareholder. See I.R.C. § 1366(d)(1).

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15 Notwithstanding the concern with such activity suggesting the taxpayer is a dealer in real estate, as discussed herein. 16 See generally, James Edward Maule, Report on the Comparison of S Corporations and Partnerships, 44 TAX LAW. 813 (1991) (American Bar Association Section of Taxation Committee on S Corporations, Subcommittee on the Comparison of S Corporations and Partnerships). 17 I.R.C. § 701 provides that partnerships are pass-through entities not subject to taxation at the entity level. Partnership income, gain, loss, deduction and credit are accounted for at the partner level, and each partner’s income is a factor of her distributive share of the partnership’s taxable income less separately allocable items of income, gain, loss, deduction and credit pursuant to I.R.C. § 702(a). 18 John F. Kennedy: “Special Message to the congress on Tax Reduction and Reform.” Jan. 24, 1963. 19 “Like kind” refers to the nature or character of the property and not to its grade or quality. Treas. Reg. § 1.103(a)-1(b); Commissioner v. Crichton, 122 F.2d 181 (5th Cir. 1941). If the taxpayer's original investment is tied up in the exchanged-for property, even with considerably different characteristics, the courts give lenient treatment to real property exchanges. See Commissioner v. P.G. Lake, Inc., 356 U.S. 260, 268 (1958); Koch v. Commissioner, 71 T.C. 54, 64 (1978); TJ Starker v. U.S., 602 F.2d 1341 (1979); CA Fed. Life Ins. v. Commissioner, 680 F.2d 85, 87 (9th Cir. 1982). The I.R.S. has given taxpayers extremely wide latitude in the kinds of replacement properties that meet the like-kind standard. Examples of these more esoteric like-kind properties include perpetual water rights, a leasehold interest with 30 or more years to run and an undivided fractional interest in property as tenants-in-common. A real flavor for the wide latitude afforded taxpayers is found in I.R.S. P.L.R. 201024036 (Feb. 23, 2010), concerning air emissions allowances under the Clean Air Act Amendments of 1990. In this P.L.R., the I.R.S. found (relying upon Rev. Proc. 92-91, 1992-2 C.B. 503) that the exchange of nitrogen oxides for volatile organic compounds were of like-kind. Accordingly, the properties exchanged must be of the same type, but they do not need to be of the same grade or quality. Real properties are generally of like-kind to all other properties, regardless of whether the properties are improved or unimproved. Personal properties are unique and must be of the same general asset class or product class. Personal property is not like-kind to real estate. While state law property classifications are relevant to this discussion, the I.R.S. has stated that it will take a “facts and circumstances” approach to the question of whether properties are of the same nature and character. See I.R.S. C.C.A. 201238027 (April 17, 2012). 20 Tax Reform Act of 1984, Pub. L. No.98-369, 98 Stat.494. 21 See generally, Economic Impact of Repealing Like-Kind Exchange Rules, ERNST & YOUNG (Nov. 18, 2015), available at http://www.1031taxreform.com/wp-content/uploads/EY-Report-for-LKE-Coalition-on-macroeconomic-impact-of-repealing-LKE-rules-revised-2015-11-18.pdf. 22 The concept of a deferred, or non-simultaneous, exchange was first recognized in Starker, supra, n.8, and remains black letter law today. See, e.g., Jessie G. Yates and Melissa Long Yates v. Commissioner, 105 T.C. Memo 2013-28, at *6, n.4. 23 The “holding” requirements have significant bearing upon an exchange preceded or followed by an acquisition, disposition or other transfer which is part of an integrated plan. See Regals Realty Co. v. Commissioner, 43 B.T.A. 194 (1940), aff’d 127 F. 2d 931 (2nd Cir. 1942) (nonrecognition denied, where the taxpayer intended to resell the replacement property at the time it was received), as well as, Rev. Rul. 75-292, 1975-2 C.B. 333 (corporate level exchange, followed by liquidating distributions of the replacement property) and Rev. Rul. 77-337, 1977-2 C.B. 305 (corporation’s liquidating distribution of the relinquished property to its shareholders, followed by shareholder level exchanges). These rulings have profound impact on the application of the “holding” requirements in connection with certain partnership transactions. Compare 124 Front Street, Inc. v. Commissioner, 65 T.C. 6 (1975), where the taxpayer was obligated to resell the replacement property, at the time it was acquired, and borrowed the funds used to acquire the replacement property from its ultimate purchaser. See also I.R.S. P.L.R. 200521002 (Feb. 24, 2005) (where a trust’s termination and distribution of its assets to the beneficiaries did not preclude the replacement property received by the trust from being considered property held either for productive use in a trade or business investment, because under the facts presented here the like-kind exchange is independent of the impending termination of the trust). Tax advisors and qualified intermediaries are frequently asked how long the taxpayer must hold a relinquished or replacement property to meet the applicable “holding” requirement under I.R.C. § 1031. The taxpayer’s intent at the time a relinquished property is conveyed or replacement property acquired is controlling. Bolker v. Commissioner, 81 T.C. 782, 804 (1983), aff’d 760 F.2d 1039 (9th Cir. 1985). Accordingly, we can only conclude that no ideal holding period will be found in law or under regulation. Because the original acquisition date of the relinquished property and the date of its transfer are both required to be disclosed on I.R.S. Form 8824, taxpayers should whenever possible acquire the replacement property after the tax year in which the relinquished property is exchanged. Although a same year disposition would not necessarily dictate that the

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relinquished property was not originally acquired and held for investment, however briefly, straddling tax years is an effective technique in expanding the holding period. To this point, prior legislative proposals have at times suggested the addition of an explicit requirement in I.R.C. § 1031 that relinquished property be held for at least one year prior to a qualifying exchange, indicating congressional recognition that such period would be considered significant for these purposes. See 16 Legislative History of the Omnibus Budget Reconciliation Act of 1989: Pub. L. No. 101-239, 103 Stat. 2106 (1989); Amendments to S. 1750 by Senator Bentsen, Oct. 12, 1989, pp. S13301-2. Additional support for a minimum one year holding period argument is the fact that Congress delineates short-term investments as though that that are held for less than one year and imposes a much higher (if not draconian) tax rate of 35% on gains. For recent cases on this point, see Yates v. Commissioner, 105 T.C.M. (CCH) 1205 (2013) (taxpayer’s exchange was disallowed when taxpayer moved into the replacement property 4 days after acquiring it), Adams v. Commissioner, 105 T.C. M. (CCH) 1029 (2013) (taxpayer’s was allowed even though he rented the replacement property to his son at below-market rents, in light of son’s level of renovation and upkeep provided to the property without charge) and Patrick A. Reesink v. Commissioner, 103 T.C.M. (CCH) 1647 (2012) (taxpayer’s exchange was allowed even the taxpayer occupied the replacement property as his primary residence a few months after acquiring it). I.R.C. § 1031(f), concerning related party exchanges, disallows nonrecognition treatment when properties in a related party exchange are disposed of within 2 years after the sale by either party to the transaction. But see Teruya Brothers Ltd. and Subsidiaries v. Commissioner, 124 T.C. 4 (2005), and Ocmulgee Fields, Inc. v. Commissioner, 613 F. 3d. 1360 (11th Cir. 2010) in which the subjective analysis of whether (a) the avoidance of federal income tax was a driving consideration for the exchange (I.R.C. § 1031(f)(2)(C)) and (b) the exchange was structured to simply avoid application of I.R.C. § 1031(f) were both implicated in addition to the procedural rule. Additional food for thought arises from the rules governing the disposition of property once held by a C corporation following its election to Sub S treatment. Here, if a corporation disposes of property within five years of electing to be an S corporation, the appreciation existing at the date of the conversion will be taxed at the corporate level. See I.R.C. § 1374(d)(7). The “special rules” enacted by Congress in response to the Great Recession that reduced the holding period to five years were made permanent in The Protecting Americans Tax Hikes Act of 2015 (PATH Act). Pub. L. No. 114-113, 129 Stat. 2242 (2015); I.R.C. § 1374(d)(7). In the absence of aggravating factors, most tax advisors will consider a 2-year hold to be sufficient, and would find the analogy to I.R.C. § 1031(f) to add comfort to this approach. A similar 2-year period is incorporated in the Treasury Regulations governing I.R.C. § 707 (the “disguised sale” rules for transactions between partners and partnerships). The problem for practitioners in rendering any advice is the fact that none of our clients are prepared to hold tight for 2 years (pun intended) when wanting to remove themselves from a partnership. The holding requirements have been the subject of significant debate in connection with the breakup of a partnership prior to an exchange, or the formation of a partnership following an exchange. For more information about the gravity of I.R.C. § 1031(f) and integrated plans of coordinated exchanges of real property, see North Central Rental & Leasing, LLC v. U.S., 779 F.3d 738 (8th Cir. 2015) (holding that the two-year holding requirement for exchanges among related parties under I.R.C. § 1031(f) was implicated because the related party, while not receiving a direct tax benefit from the taxpayer’s like-kind exchange, it received a major financial benefit from receiving pre-tax proceeds for a short time). See also, Richard M. Lipton, Eighth Circuit Sheds Light on Like-Kind Exchanges, 122 J. Tax’n 262 (June 2015). For more on related parties, see I.R.C. § 267(b) and I.R.C. § 707(g)(1) for the “attribution” rules. 24 I.R.C. § 1221(1) provides that a capital asset does not include "property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.” See Loren F. and Donna Paullus & Ridgemark Corp. v. Commissioner, 72 T.C.M. (CCH) 636 (1996); Treas. Reg. § 1.1031(a)-1. See also, F. McNair, M. Lynch and N. Lynch, Attaining Capital Gains Treatment of Property Transactions: Dealer Versus Investor, 77 CPA J. 44 (June 1, 2007). But see Loughborough Dev. Corp. v. Commissioner, 29 B.T.A. 95, 98-99 (1933) (property acquired by real estate developer in exchange deemed eligible for nonrecognition treatment under I.R.C. § 1031 on finding that the property had not been accumulated for immediate sale). In situations not involving dealers, the Tax Court has interpreted the holding requirement in light of each individual set of facts. In doing so, the Tax Court has not limited the primarily-for-sale prohibition to dealers. In one case the Tax Court held that a single-family home acquired in a like-kind exchange was taxable since the taxpayer offered the property for sale and did sell it shortly after she finished painting it. Black v. Commissioner, 35 T.C. 90, 96 (1960). In short, whether particular real estate qualifies for such treatment is decided on a case by case basis, taking into consideration many factors, including the number and frequency of sales, subdividing activities and promotional efforts. 25 For the property you transfer by exchange or sale, it is the total of all consideration you receive; that is, cash plus the fair market value of all property or services you receive, minus the adjusted basis of the property. The amount realized also includes any liabilities assumed by the buyer — such as the assumption of a debt of the seller or the payment of seller’s closing costs — and any liability to which the transferred property is subject, such as real estate taxes or assessments.

26 Before enactment in 1991 of the Treasury Regulations governing I.R.C. § 1031, the delayed, or any other non-simultaneous, exchange was commonly termed the “starker exchange”, referring to the 1979 court case of Starker noted above. In response to the court’s decision, Congress amended the Code to create very specific rules and restrictions governing tax-deferred exchanges and to limit a court’s discretion in evaluating the transaction on a facts and circumstances basis only. See n.23, supra.

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27 Treas. Reg. § 1.1002-1(b), n.10; Leslie Co. v. Commissioner, 64 T.C. 247, 252 (1975), aff’d. 539 F. 2d 943 (3d Cir. 1976); Black v. Commissioner, 35 T.C. 90, 94 (1960). For practitioners unfamiliar with the basic all-inclusive income concept of the Code, all income received is taxable unless a provisions of the law specifically excludes it. Any tax relief provided from this general concept is the result of specific acts of Congress which are strictly interpreted and applied to the facts of the taxpayer’s circumstances. 28 H. Rept. No. 704, 73d Cong., 2d Sess. (1934), 1939-1 C.B. (Part 2) 554, 564; Jordan Marsh Co. v. Commissioner, 269 F. 2d 453, 455-456 (2d Cir. 1959); Biggs v. Commissioner, 69 T.C. 905, 913 (1978), aff’d. 632 F. 2d 1171 (5th Cir. 1980). 29 Jordan Marsh Co. v. Commissioner, 269 F.2d 453, 456 (2d Cir. 1959). 30 The expression of this principle is succinctly captured in Maloney v. Commissioner, 93 T.C. 89 (1989), a case involving a corporation that exchanged real property (the “I-10” property for “Elysian Fields”) followed by a liquidating distribution of all corporate assets, including the replacement property (Elysian Fields) to its shareholders under former I.R.C. § 333. The court concluded that the petitioners “did not intend to cash out their investment in the property received”, noting that the taxpayer’s “economic situation is in substance the same” before and after the transaction and allowing nonrecognition treatment since “petitioners continued to have an economic interest in essentially the same investment, although there was a change in the form of ownership.” Id. at 96. The underlying assumption of I.R.C. § 1031 is that the new property is substantially a continuation of the old investment still unliquidated. Commissioner v. P.G. Lake, Inc., 356 U.S. 260, 268 (1958); Koch v. Commissioner, 71 T.C. 54, 64 (1978). 31 The word “primarily” is viewed as being held “principally” or “of first importance.” Malat v. Riddell, 383 U.S. 569 (1966). 32 4 MERTENS LAW OF FED. INCOME TAX’N §22A:29. 33 To be sure, the U.S. Treasury is not forever deprived of tax revenue (except upon the death of the taxpayer, assuming the stepped-basis rules continue to exist). Code Section 1031(d) provides that the basis of the replacement property equals the basis of the relinquished property, less any cash received and any loss recognized and increased by any gain recognized or any cash paid by the taxpayer to acquire the replacement property. The typical exchange requires a “property-by-property” comparison for computing gain recognized in the transaction. See Yates, supra n.22, at *4. Except upon death of the taxpayer, “[l]ike-kind exchanges result in tax deferral, not tax elimination.” Richard M. Lipton, Samuel P. Grilli and Samuel Pollack, The “State of the Art” in Like-Kind Exchanges-2015, 124 J. Tax. 5 (Jan. 2016). Upon the eventual sale of the property, Uncle Sam will get its due. 34 Actually termed the Patient Protection and Affordable Care Act, 124 Stat. 119, the law survived constitutional challenge regarding the “individual mandate” and the Medicaid expansion at the heart of the legislation. See National Federation of Independent Business v. Sebelius, Secretary of Health and Human Services, 132 S. Ct. 2566 (2012). 35 Pursuant to I.R.C. § 1411, the Medicare surtax applies to all net investment income above the thresholds. Net investment income includes interest, dividends, capital gains, retirement income and income from partnerships (as well as other forms of “unearned” income). The thresholds are adjusted for inflation. For 2015 returns, the thresholds were $431,201 and 464,851, respectively. 36 For 2015, the top capital gain rate in Minnesota applies to single filers with income of $154,950 and married joint filers with income of $258,261. 37 Kyle Pomerleau, The High Burden of State and Federal Capital Gains Tax Rates in the United States, TAX FOUNDATION (Mar. 2015), available at http://taxfoundation.org/sites/default/files/docs/TaxFoundation_FF460.pdf. 38 Under current law, gain on the sale of capital assets held more than a year are taxed at a flat 15 percent rate for most U.S. taxpayers. The capital gains of taxpayers in the 10 and 15 percent federal income tax brackets are exempt from all taxation. The capital gains rate for taxpayers in the top marginal federal income tax bracket (39.6 percent) is 20 percent. Capital gains on the sale of capital assets held less than a year are taxed at an individual’s ordinary income tax rate. Qualified dividends — paid by American companies or qualified foreign companies on stock held for at least 60 days — are currently taxed at 20 percent for the highest-income earners, whereas ordinary (nonqualified) dividends and interest are taxed at regular income tax rates. 39 For an excellent summary of this study, see https://www.cbo.gov/publication/51831. 40 See n.21, supra, Figure 1 and Table 1, at page 5. 41 3 MERTENS LAW OF FED. INCOME TAX’N §§ 21.52 to 21.67.

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42 David C. Ling and Milena Petrova, The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges in Real Estate, REAL ESTATE LIKE-KIND EXCHANGE COALITION (June 2015), available at http://www.1031taxreform.com/wp-content/uploads/Ling-Petrova-Economic-Impact-of-Repealing-or-Limiting-Section-1031-in-Real-Estate.pdf.

43 Tax Reform Act of 1984, Pub. L. No. 98-369, 98 Stat. 494; I.R.C. § 1031(a)(2)(D); Rev. Rul. 78-135, 1978-1 C.B. 256. In addition to partnership interests, Congress excluded from I.R.C. § 1031 the exchange of (i) stock in trade or other property held primarily for sale, (ii) stocks, bonds or notes, (iii) other securities or evidences of indebtedness or interest, (iv) certificates of trust or beneficial interests, (v) choses in action and (vi) real property located in the U.S. for real property located outside the U.S. See I.R.C. § 1031(a)(2) & (h)(1). Congress also amended I.R.C. § 1031 to provide that the Taxpayer’s time within which to identify replacement property would expire 45 days after transfer of relinquished property; and that the Taxpayer’s time within which to complete an exchange would expire 180 days after transfer of the relinquished property, or upon the due date of the Taxpayer’s tax return for the tax year in which the transfer of relinquished property occurred, whichever date is earlier Most importantly, in the Conference Report accompanying the 1984 Act, Congress specifically reaffirmed that a “sale” followed by reinvestment in like-kind property doesn’t qualify for tax deferral. It is still essential to conservatively structure an exchange to avoid actual or constructive “receipt” of proceeds of sale and to prevent characterization of the transaction as a taxable sale and reinvestment. 44 Under I.R.C. § 703(a), the taxable income of a partnership is computed in the same manner as for an individual, subject to certain exceptions which are not pertinent to like-kind exchanges. Therefore, a partnership is entitled to nonrecognition treatment under I.R.C. § 1031(a) when the partnership exchanges property held by it for investment for property of like-kind which is to be held by the partnership for investment. Just as the character of items of income taken into account by the respective partners is determined under I.R.C. § 702(b) at the partnership level, the “qualified use” requirement under I.R.C. § 1031 should be analyzed at the partnership level. For example, even if a particular partner is a dealer in real property, neither the partnership nor such partner would be required to recognize income on a partnership level exchange if the partnership is not a dealer with respect to that property. 45 Treas. Reg. § 1.1031(a)-1(e).1(e). 46 See General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, prepared by the Staff of the Joint Committee on Taxation, at 245-47. See also Rev. Rul. 84-52, 1984-1 C.B. 157 (addressing the conversion of a four-person state-law general partnership into a limited partnership in the same state, with two partners becoming limited partners and two partners becoming both limited and general partners and in which each partner's total percent interest in the partnership's profits, losses, and capital remained the same). See also I.R.S. C.C.A. 2015-17-006 (Apr. 24, 2015). 47 Rev. Rul. 78-135, 1978-1 C.B. 256. Two exceptions apply to this general rule: A taxpayer acquires 100 percent of the interests of the partners in a partnership that holds real property, pursuant to Rev. Rul. 99-6, 1999-1 C.B. 432, or the taxpayer contributes qualifying property to a REIT pursuant to I.R.C. § 721 (the “upREIT” transaction). 48 See I.R.S. P.L.R. 200807005 (Nov. 9, 2007) and Supplemental Report of the House Ways and Means Committee, 98th Cong., 2d Sess., H. R. Rep No. 432 (Part 2) at 1232-34 (1984). 49 Christopher H. Hanna, Partnership Distributions: Whatever Happened to Nonrecognition?, 82 KY. L. J. 465 (Winter, 1993/1994). 50 I.R.C. § 703(a). 51 Rev. Rul. 2003-56, 2003-1 C.B. 985 (interpreting the liability netting rules for an entity level exchange by a partnership). 52 Suburban Realty Co. v. United States, 615 F.2d 171 (5th Cir. 1980)(indicating that a taxpayer may obtain capital gain treatment on the sale of a clearly segregated tract of land). For more on this issue, attention to the Fifth Circuit’s framework is highly recommended. In addition to Suburban Realty, see also Biedenharn Realty Co. v. United States, 526 F.2d 409 (5th Cir. 1976) and United States v. Winthrop, 417 F.2d 905 (5th Cir. 1969). The sale of 5 or fewer lots/parcels from the same tract of land during a taxable year enjoys capital gain treatment under Treas. Reg. § 1.1237-1(e)(2). See Neal T. Baker Enterprises, Inc. v. Commissioner, 76 T.C.M. (CCH) 301 (1998) (taxpayer failed to convince the court that it held vacant land for investment rather than for sale and listed on its tax returns that it was engaged in the business as a “real estate subdivider and developer” as the company’s principal business activity and classified the land as inventory on its financial statements). 53 I.R.C. § 1031(a)(2) 54 9 MERTENS LAW OF FED. INCOME TAX’N §35:6.

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55I.R.S. P.L.R. 200937007 (March 10, 2009). 56 I.R.S. P.L.R 201002034 (October 1, 2009). 57 9 MERTENS LAW OF FED. INCOME TAX’N §35A:29. 58 I.R.S. F.S.A. 199923017 (June 11, 1999). 59 9 MERTENS LAW OF FED. INCOME TAX’N §35A:48. 60 See Carlene Y. Lowry, Catherine Skokowski, Charlotte Chyr and Glenn Mincey, Revenue Ruling 99-6, a Trap for the Unwary, A.B.A. Sec. of Tax’n, P’ship & LLCs Comm., 2011 Fall Meeting Denver, Colorado (Oct. 2011), available at http://www.americanbar.org/content/dam/aba/events/taxation/taxiq-fall11-skokowski-99-6-slides.authcheckdam.pdf. 61 I.R.S. P.L.R. 200807005 (Feb. 15, 2008). 62 I.R.S. P.L.R. 200909008 (Feb. 2009). 63 A reverse exchange is one in which the taxpayer, following Rev. Proc. 2000-37, 2000-2 C.B. 308, and Rev. Proc. 2004-51, 2004-2 C.B. 294, contracts with the Exchange Accommodation Titleholder (“EAT”)to acquire and hold the replacement property while taxpayer closes on the sale of the relinquished property. It is for this reason that the reverse exchange should be referred to as a parking arrangement, in which an unrelated third party EAT holds title to the replacement property during the exchange period to permit the taxpayer to conduct a like-kind exchange when the relinquished property is still held by it. Rev. Proc. 2000-37 provides a safe harbor under I.R.C. § 1031 for an exchange where the taxpayer acquires the replacement property before transferring the relinquished property. 64 45 T.C. 588 (1966). 65 Id. At 590. 66 See John P. Napoli and John F. Smith, Emerging Issues in UPREIT Transactions, 26 J. REAL EST. TAX’N 187 (1999). 67 Id. at 196-200. 68 See Bradley T. Borden, Reforming REIT Taxation (or Not), 53 Hous.L.Rev. 1 (2015), and Russel J. Singer, Understanding REITS, UPREITS, and DOWN-REITS, and the Tax and Business Decisions Surrounding Them, 16 VA. TAX REV. 329 (1996). 69 Available at: http://www.globaleconomicandinvestmentanalytics.com/archiveslist/articles/210-understanding-the-complexities-of-upreits-and-downreits.html. 70 The Redemption Right generally can be immediately exercisable by the holder unless the REIT engages in a public offering of its common shares close in time to the issuance of the OP Units. In that event, the securities laws may require that the Redemption Right not be exercisable during the first year after the OP Units are issued. 71 See Napoli and Smith, supra n. 66, at 202-206. The built-in gain of a property is the difference between the Selling Partnership’s adjusted basis in the property and its fair market value at the time of the transfer. 72 The Operating Partnership can also acquire properties by issuing cash and/or OP Units directly to the Selling Partners in exchange for their interests in the Selling Partnership. See Blake D. Rubin et al., Handling UPREIT and DOWNREIT Transactions: Latest Techniques and Issues, ALI-CLE, Creative Tax Planning for Real Estate Transactions (April 23-24, 2015). 73 Delaying the distribution of the OP Units minimizes the risk that the I.R.S. might challenge the allocation of all of the taxable gain from the transfer to the Cash-Out Partners. In addition, a Selling Partnership may want to delay the distribution of the OP Units for non-tax reasons (e.g., the OP Units collateralize representations and warranties made by the Selling Partnership to the Operating Partnership). 74 See also Treas. Reg. § 1.707-3. These rules are subject to proposed regulations issued by the I.R.S. on January 29, 2014. C.C.A. 200250013 (Dec. 13, 2002) provides an example of application of the disguised sales rules to the liquidation of a two-partner partnership using a common technique.

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75 For more on this subject, see Mark J. Silverman and Aaron P. Nocjar, Partnership Disguised Sale Rules, P.L.I., Tax Planning for Domestic & Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances 2013 (Dec. 2012). 76 If the OP Units are held by the Selling Partnership, the Equity Partners will recognize their allocable share of the gain or loss recognized by the Selling Partnership on the sale or redemption of the OP Units. 77 Compare Mason v. Commissioner, T.C. Memo 1988-273, with Chase v. Commissioner, 92 T.C. 874 (1989). 78 The I.R.S. amended Schedule B of Form 1065 to elicit this very information from taxpayers by adding items 13 (“Check this box if, during the current or prior tax year, the partnership distributed any property received in a like kind exchange or contributed such property to another entity (including a disregarded entity”) and 14 (At any time during the taxpayer year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property?”). To avoid application of this doctrine to the taxpayer’s affairs, the transaction at issue must be realistic in an ordinary sense and not contrived merely to avoid tax. See Gregory v. Helvering, 293 U.S. 465 (1935) (notice that a taxpayer is bound by the economic substance of a transaction where the economic substance varies from its legal form). 79 See I.R.S. P.L.R. 9741017 (July 10, 1997), wherein the I.R.S. ruled that a proposed exchange between two partners, each of whom owns 50 percent of a partnership that owns 10 rental properties, will not qualify for nonrecognition treatment under I.R.C. § 1031, because the partners would be exchanging partnership interests even though management differences motivated the partners to realign ownership of the properties so that one partner owned six and the other three while the partnership retained title to the remaining property. 80 Richard Lipton characterizes the timing issue of the transfer of the partnership interest in the underlying real estate into the undivided interests held by the (former) individual partners as critical, noting that too aggressive an approach will allow the I.R.S. to successfully argue “that the transaction should be characterized as a sale of the property by the partnership, the intervening distribution notwithstanding.” Richard Lipton, The “State of the Art” in Like-Kind Exchanges, 2006, 104(3) J. OF

TAX’N 138, 149 (March 2006). 81 81 T.C. 767 (1983), aff’d 753 F. 2d 1490 (1985). 82 Magnuson, supra, at 770. 83 Rev. Rul. 75-292, 1974-1 C.B. 43, is applicable to a prearranged transaction by which an individual transferred land and buildings used in his trade or business to an unrelated corporation in exchange for land and an office building followed by the individual’s immediate transfer to a corporation created by the individual in exchange for stock in the corporation under I.R.C. § 351. 84 81 T.C. 782 (1983). 85 Id. at 806 (citing Jordan Marsh Co. v. Commissioner, 269 F.2d 453, 456 (2d Cir. 1959)). 86 760 F.2d 1039 (9th Cir. 1985). 87 Id. at 1044-1045. 88 By way of background, two important revenue rulings were at play during consideration of some of the groundbreaking cases under I.R.C. § 1031 (and occurred under the 1954 Code). In Rev. Rul. 75-291, 1975-2 C.B. 333, the I.R.S. discussed a situation where a corporate taxpayer purchased land and constructed a factory thereon solely for the purpose of exchanging the tract of land and new factory for land and an existing factory owned by another taxpayer. The I.R.S. held that with respect to the corporate taxpayer, the exchange did not qualify for nonrecognition treatment under I.R.C. § 1031(a) since the corporation did not held the property for productive use in its trade or business or for investment. Similarly, Rev. Rul. 75-292, 1975-2 C.B. 333, discussed the tax consequences to an individual taxpayer who, in a prearranged transaction, transferred land and buildings used in the taxpayer's trade or business to an unrelated corporation, in exchange for land and an office building owned by the corporation. Immediately thereafter, the taxpayer transferred the land and an office building to a corporation created by the taxpayer in exchange for the stock in the corporation in a transaction that qualified under I.R.C. § 351. The I.R.S. held that the transaction between the taxpayer and the unrelated corporation does not qualify for nonrecognition treatment under I.R.C. § 1031(a) with respect to the taxpayer, since the taxpayer did not exchange the land and buildings for property to be held either for productive use in trade or business or for investment. Rev. Rul. 75-291, 1975-2 C.B. 333, requires that a taxpayer hold the property to be exchanged for productive use in trade or business for investment. In Revenue Ruling 75-292, 1975-2 C.B. 333, the I.R.S. indicated that a corporation's productive use of an asset in its trade or business may not be attributed to its sole shareholder.

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89 See Analysis of Revenue Ruling 75-292: A Proposal to Allow the Combined Use of Sections 1031 and 351 Without Destroying the Tax-Free Status of Either, 17 WM. & MARY L. REV. 599 (1976). 90 In the Matter of Consolidated Appeal of Diamond and Aries, State of California Board of Equalization, Case No. 441030 and 464475. The undated Slip Opinion in Appeal of Diamond & Aries, Nos 441030 and 464475, is available at https://www.boe.ca.gov/meetings/pdf/hearingsummaries/item_b_diamond_and_aries_441030_464475_sum.pdf. 91 Marks v. Dep’t of Revenue, Oregon Tax Court, No. TC-MD 050715D (July 24, 2007), and Department of Revenue v. Marks (Or.T.C.2009), 20 OTR 35. 92 Appeal of Rago Development Corporation, Appeal No. 735761 (June 23, 2015). 93 92 T.C. 874 (1989). 94 Id. at 879. 95 81 T.C. 782 (1983), aff’d 760 F.2d 1039 (9th Cir. 1985). 96 I.R.S. P.L.R. 9645005 (July 23, 1996). 97 450 F.2d 472 (5th Cir.1970). 98 This discussion intentionally excludes the use of fractional ownership interests as replacement property in I.R.C. § 1031 exchanges following the dictates of Rev. Proc. 2002-22, 2002-1 C.B. 733. Although the I.R.S. did not establish a safe harbor provision, it did spell out some requirements for TIC interests to qualify as co-ownership interests in that revenue procedure. One of the debilitating features of qualifying TIC interests for like-kind exchanges is the dictate that all decisions affecting the entity require the unanimous approval of the co-owners. As a result of this limitation, the Delaware Statutory Trust has largely replaced the TIC offering. Rev. Rul. 2004-86, 2004-2 C.B. 191, permits an entity known as a Delaware Statutory Trust to hold fee title to replacement property in an exchange rather than individual tenants in common. Under this structure, tenants in common own interests in the trust rather than undivided interests in the real estate, and a trust company is typically hired to act as trustee. Furthermore, given that such trusts are considered “disregarded entities” for federal income tax purposes, interests in such trusts are considered to be owned by the individual trust beneficiaries. 99 Rev. Rul. 75-374, 1975-2 C.B. 261. 100 Treas. Reg. § 301.7701-1(a)(2). The I.R.S. has provided favorable guidance in parsing out the distinction between co-owner versus partner-like activity. In Rev. Rul. 75-374, 1975-2 C.B. 261, the I.R.S. concluded that the ownership and operation of an apartment project does not constitute an active business so long as the owner furnishes only “customary” tenant services (which, in that case, were said to include the provision of heat, air conditioning, hot and cold water, unattended parking, normal repairs, trash removal and cleaning of public areas). In the ruling, it was also noted that the owner would not be considered to engage in an active business if additional services were to be furnished by an independent party, not acting as the agent of the owner. P.L.R. 8117040 (January 27, 1981) indicates that the owner of an apartment community can also arrange for the provision of laundry equipment and services by a third party, and receive a fee based on a percentage of the gross laundry income, without being considered to actively engage in a business. 101 I.R.S. P.L.R. 9741017 (July 10, 1997). 102 See also Tech. Adv. Mem. 199907029 (September 30, 1998). 103 93 T.C. 89 (1989). 104 Id. at 96. 105 T.C. Memo 1988-273 (June 27, 1988). 106 Tech. Adv. Mem. 9818003 (Dec. 24, 1997). 107 I.R.S. C.C.A. 200650014 (Dec. 15, 2006).

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108 The Chief Counsel also applied the partnership anti-abuse rules under Treas. Reg. § 1.701-2, noting that the anti-abuse rules recast the transaction if its principal purpose is to substantially reduce the present value of the partners’ aggregate federal tax liability in a manner in consistent with subchapter K. 109 See Blake D. Rubin et al., Partnership Equity Extraction Techniques, ALI-CLE, Creative Tax Planning for Real Estate Transactions (April 23-24, 2015) and Blake D. Rubin and Andrea Macintosh Whiteway, Application of the Anti-Mixing Bowl Rules after a Partnership Merger: Rev. Rul. 2004-43 Gets it All Wrong, 7 J. OF PASSTHROUGH ENTITIES, No. 4, 7 (July/August 2004). 110 9 MERTENS LAW OF FED. INCOME TAX'N § 35:16. 111 See Bradley T. Borden et al., Avoiding Adverse Tax Consequences in Partnership and LLC Reorganizations, A.B.A. BUS. LAW TODAY (December 2013). 112 93 T.C. 89 (1989). 113 Diamond and Aries, supra n. 90. 114 David R. Chan, Drop and Swap: Can You Relax if the Police Aren’t Looking For You, available at: http://www.csun.edu/sites/default/files/10-46-1-PB.pdf. 115 Id. at 3. For a thorough description of the mixing bowl transaction, see Christian M. McBurney, Mixing-Bowl Transactions and the Partnership Disguised Sale Regulations, 70 TAXES 123 (1992). 116 Treas. Reg. § 301.7701-(3)(b)(1) provides that single member LLCs that acquire property are ignored for federal tax purposes and that the sole member is treated as the direct owner of the real property. The IRS has issued private letter rulings holding that the disposition of the relinquished property or acquisition of the replacement property by a disregarded entity of the taxpayer will be treated for I.R.C. § 1031 purposes as a direct disposition or acquisition of the real property by the taxpayer. See, e.g., I.R.S. P.L.R. 9807013 (Nov. 13, 1997). 117 Rev. Rul. 64-161, 1964-1 C.B. 298. 118 I.R.S. P.L.R. 8429004 (Mar. 22, 1984). 119 I.R.S. P.L.R. 9227022 (Apr. 1, 1992). 120 I.R.S. P.L.R. 99935065 (Sept. 28, 1998). 121 Tech. Adv. Mem. 9252001 (Feb. 12, 1992); I.R.S. P.L.R. 200151017 (Sept. 17, 2001); Merkra Holding Co., Inc. v. Commissioner 27 T.C. 82, 90 (citations omitted). 122 65 S. Ct. 707 (1945). 123 Supra, n. 88. 124 United States v. Cumberland Public Service Co., 70 S. Ct. 280, 283, n.3. The Supreme Court noted that: “We were but emphasizing the established principle that in resolving such questions as who made a sale, fact-finding tribunals in tax cases can consider motives, intent, and conduct in addition to what appears in written instruments used by parties to control rights as among themselves.” Id. 125 Id. 126 Id. at 282. 127 Id. at 283, n.3. 128 Merkra, supra, n. 121. 129 Id. at 91.

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130 For a general explanation of how the receipt of like-kind replacement property and an installment note does not jeopardize an exchange, see 2 MERTENS LAW OF FED. INCOME TAX’N §15:33. 131 Lou Weller, Managing Partner of Weller Partners LLP and Managing Director of Stewart Institutional Exchange Services, LLC. Mr. Weller was formerly the national director of real estate tax transaction planning at Deloitte Tax LLP. See http://www.wellerpartnersllp.com/. 132 Treas. Reg. § 1.453-9(c)(2). It would be permissible for the installment note to be secured by a standby letter of credit. Treas. Reg. § 15A.453-1(b)(3). 133 The proposed regulations for I.R.C. § 453 retain this approach. See Proposed Regulations Section 1.453B-(c)(1)(C). 134 Treas. Reg. § 1.704-1(b) sets forth safe-harbor partnership allocations that meet one of three requirements. See 9 MERTENS

LAW OF FED. INCOME TAX'N § 35:68. 135 Treas. Reg. § 1.704-1(b)(2)(i). 136 Treas. Reg. § 1.704-1(b)(2)(ii)(b). 137 American Bar Association Taxation Section’s Joint Report on IRC Section 1031 Open Issues Involving Partnerships (February 21, 2001), available at: http://www.americanbar.org/content/dam/aba/migrated/ftp/pub/tax/policy/010208rpt1031.authcheckdam.pdf.