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Musings on Implications of the Repeal of the Technical Termination Provisions Under IRC 708 for 1031 Exchanges

The real estate industry customarily uses limited liability companies or limited partnerships(herein “partnerships”) to hold real estate assets due to the tax flexibility under Subchapter K.  A common issue arises when it comes time to sell the underlying real estate asset and some owners (herein “owners” or “partners”) want to exchange while others do not.   While there are several alternatives to resolving the disagreement among  the owners which are not addressed in this memorandum, a common technique is to have either the other owners, of the entity buy out the owners who do not want to exchange.    Whenever this technique was used prior to 2018, one of the major risks is whether or not there would be a technical termination as a result of the buy out of an owner’s interests.    Under IRC 708(b)(1)(B) a “technical termination” took place when there was a sale or exchange of 50 percent or more of the total interest in capital and profits within a 12 month period.   While there are many interesting questions concerning “what is a 12 month period” and what is a “total interest in capital and profits” none of those questions are pertinent to this memorandum.   Assuming that the buy out of owners who did not want to exchange would cause a technical termination, then the effect is that the resulting partnership consisting of the continuing partners, would be a new partnership for tax purposes and that would endanger  the exchange since if the “old partnership” initiated the exchange and the “new partnership” completed the exchange since the same taxpayer was not involved throughout the exchange.    The topic to be addressed here is what steps were historically taken to mitigate the risk of disqualification, how the 2018 change in the tax law affects this analysis and some possible protective measures to be taken prospectively.

There are two points in time that owner buyouts can be effected, before the closing date or after the closing date of a proposed sale by a partnership.  Clearly, if the buy out of a partner is “old and cold” by the time that an agreement to sell the property is signed, there is nothing to worry about.  What is “old and cold” could be the topic of a separate debate, but for purposes of this memorandum, it will be assumed that the buy out is connected with the proposed sale and takes place relatively near the date of closing.   The “pre closing” time periods can further be divided into buyouts that take place before an contract is signed and buyouts that take place after a contract is signed.   If the buyout is before any contract or binding letters of intent are signed, then even if the buyout caused a technical termination, in most instances it would be the new partnership that signed the contract and completed the exchange so there should not be a problem.   If the buy out takes place after the contract is signed and before closing, and the buyout resulted in a technical termination then there would be different taxpayers involved in the transaction and could endanger the exchange.   Arguments could be made that if the contract was still “contingent” due to various provisions that a technical termination prior to satisfaction of those contingencies should not adversely affect the exchange, but if the contract was firm, then the effect of a technical termination would be a transfer of the property and contract to a new partnership and there could be issues raised as to whether or not the new partnership cold qualify for an exchange under the Court Holding Company line of cases which the service has applied to exchanges.   If the buy out of a partner took place after closing and before completion of the exchange, and resulted in a technical termination, then the exchange was a high risk since the exchange started with one taxpayer and ended with another.

In order to mitigate against the risk of disqualification of an exchange due to a technical termination, the most common palliative was to structure the buyout as a redemption of a partner under IRC 736.   The law is clear that a distribution to a partner, even a liquidating distribution, is not a sale or exchange and IRC 708(b)(1)(B) would not apply.  While comfort can be obtained by relying on wording of the statutes, WKBKY has always been concerned that if the percentage interest redeemed  is too much, that a judicial gloss might be added to disqualify the exchange.  For example, if 98% of the partners are redeemed out and only 2% are left to exchange, will the partnership still be considered the “same” taxpayer for IRC 1031?  This issue is compounded if the deal is structured not only to redeem out old partners but also to admit new partners by way of capital contribution.   This type of structure so closely resembles a buy out of the old partners, it is hard to justify, other than by a technical reading of the statute, as to why a buy out would cause a technical termination and a redemption and admission would not.

Fortunately, the repeal of the technical termination provisions effective as of January 1, 2018 alleviates most of this concern.   WKBKY continues to have concern about transactions which result in too much of a transfer of interests, such as the 98%/2% example above.   With more normal type buy outs, the repeal of the technical termination provisions mean that the same taxpayer exists before and after a sale of a partnership interest and therefore it should not make any difference when the buy out is effected.  The buy out could take place before contract signing, after contract signing, after close of escrow and midstream exchange, or after the exchange and the result should be the same: the exchange should meet the same taxpayer test.

If there is a large shift in ownership, let’s say that 60% of the partners are cashing out and 40% are going to exchange WKBKY would suggest using the redemption structure as above described as an additional layer of protection.

Additional questions arise if the source of funding of the buyouts is from a loan obtained and secured by the property and used to fund the buy outs.   This type of activity can introduce boot risks that need to be examined but are beyond the scope of this memorandum.    Further attention should be given to the disguised sale rules if the buy out of a partner is effected by way of a transfer of property by the partnership to the partner in whole or in part.

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