Planning for UPREIT transactions when selling partners want to go their separate ways

Journal of Taxation

Volumn 90, Issue 4, 1999, Pages 238-250

  Crnkovich, Robert J ^a,c   Lowy, James M ^a,b  

^a ERNST AND YOUNG LLP   (United States)

^b Real Estate Committee   (United States)

^c GEORGETOWN UNIVERSITY LAW CENTER   (United States)

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EID: 33749092585     PISSN: 00224863     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Article

References (68)

1. "UPREIT" generally refers to a tiered ownership structure consisting of a real estate investment trust (a REIT) and a limited part-nership (an "operating partnership," or OP) that holds real estate, with the REIT's sole asset being a general (and, possibly, limited) partner interest in OP. Owners of property contribute their real estate to OP, in transactions generally intended to be tax-free under Section 721, in exchange for limited partner interests that are effectively convertible, at the option of the holder (following a negotiated "lock up" period), into cash or publicly traded REIT shares. Because the REIT's only asset is the OP interest, participation in OP effectively provides a property contributor with the same economic benefits as REIT share ownership, other than liquidity. Moreover, the values of the REIT shares and OP "units" theoretically should rise and fall in tandem, based on the performance of the OP's portfolio. Liquidity is available on the exercise of the option to convert the OP interest into REIT shares or cash, although any such conversion is a taxable event. A related structure is the "DownREIT," which is intended to enable a traditional REIT (i.e., a REIT that owns real estate directly) to offer to a property contributor the same tax deferral opportunity available from an UPREIT. Much like an UPREIT, a DownREIT generally consists of a limited partnership between a traditional REIT (holding the general partner interest) and one or more property contributors (who own the limited partner interests). Unlike an UPREIT, where a property contributor to the UPREIT OP participates in the economics associated with the REIT's entire real estate portfolio, a property contributor to a DownREIT, prior to converting to REIT shares, participates directly only in the assets of the DownREIT partnership.
2. See McCauslen, 45 TC 588 (1966), and Rev. Ruls. 68-289, 1968-1 CB 314, and 99-6, 1999-6 IRB 6.
3. ABC's section 704(b) book and tax depreciation deductions are identical, although a Section 704(c) book-tax disparity exists with respect to nondepreciable land C.
4. Land D and land E each has appreciated by $30; the remainder of the appreciation is attributable to property C.
5. There has been no book-up of the property under Reg. 1.704-1(b)(2)(iv)(f); there is no disparity between the inside and outside bases (as could occur if one of the partners had sold an interest in ABC at a gain or loss and ABC did not make a Section 754 election); the partnership's liability is a "qualified liability" as defined in Reg. 1.707-5(a)(6); and ABC never terminated under Section 708 (under pre-1997 law, a Section 708 partnership termination could have resulted in, among other consequences, "exploding" bases and a multiplicity of Section 704(c) properties). A change in any of these assumptions would complicate the analysis.
6. While the tax capital accounts will remain unchanged in a units-only transaction, the partners each will have Section 704(b) book capital accounts in OP of $300, the FMV of their interests.
7. See Regs. 1.707-3(c) and (d). Moreover, "safe harbor" exceptions exist for distributions within the two-year period that are reasonable guaranteed payments or preferred returns, "operating cash flow distributions," and "reimbursements of pre-formation capital expenditures." Reg. 1.707-4.
8. See, e.g., Reg. 1.707-3(f), Example (1).
9. For instance, the transfer to a partnership of property with an FMV of $100 that is subject to $60 of purchase money debt (i.e., $40 of equity) in exchange for $30 of partnership interests and $10 of cash generally will be a disguised sale of 25% of the property, and result in an amount realized of $25 ($10 plus 25% of $60), as described in greater detail below.
10. This determination is made under special rules in the disguised sale Regulations, rather than under Section 752.
11. See Reg. 1.752-1(a)(1).
12. Reg. 1.707-5(a)(1). The "third tier" allocation generally is in accordance with a partner's share of partnership profits.
13. Reg. 1.707-5(a)(1).
14. As described in the text immediately below, this assumes that the units to be received by ABC represent a small percentage interest in OP.
15. A DRO or guarantee of other debt may allow the partner to retain the same amount of debt for purposes of Section 752 (which can, among other consequences, defer gain otherwise reportable under Section 731(a), as discussed in the text, below); however, the disguised sale Regulations under Section 707(a)(2)(B) generally require that the same debt be allocated back to the partner to avoid any disguised sale consideration.
16. See note 8, supra.
17. The amount realized, basis, and gain attributable to each property are $500, $160, and $340 (for property C), $60, $50, and $10 (land D), and $40, $30, and $10 (land E).
18. It appears that distributions that are subject to the preformation capital expenditure rule must be disclosed by the partner receiving the payment. The disguised sale Regulations require disclosure by a transferring partner of any purported contribution to a partnership where there is a transfer to such partner within two years and the transfer to the partner is not excepted from the disguised sale rules as a reasonable guaranteed payment or preferred return and is not an operating cash flow distribution. Regs. 1.707-8(a), 1.707-3(c)(2). It is unclear why transfers subject to the preformation capital expenditure exception do not warrant similar relief from the disclosure requirement. Indeed, in Ltr. Rul. 9829027 the IRS ruled that a transaction was not a disguised sale because the distributions to the transferring partner were within the preformation capital expenditure safe harbor but refused to rule that disclosure was unnecessary. Whether there is a penalty for the failure to disclose in such cases is uncertain.
19. The 20% test is a "to the extent" rule, thereby protecting reimbursements up to the 20% level even if excess amounts are paid. The disguised sale Proposed Regulations would have provided for a "cliff" test, whereby any reimbursement in excess of 20% would have tainted the entire reimbursement. See former Prop. Reg. 1.707-4(d)(2)(ii) (PS-163-84, 4/25/91).
20. Reg. 1.707-4(d). Unlike the "to the extent" nature of the 20% test (see note 19. supra), failure to satisfy the 120% test (by even $1) will subject the transaction to the more limited 20% test.
21. The preformation capital expenditure exception appears to apply on an aggregate basis, rather than a property-by-property basis, to the transferring partner. Reg. 1.707-4(d)(2)(ii) refers to capital expenditures incurred by the partner during the preceding two years with respect to contributed property, to the extent the reimbursed expenditures do not exceed 20% of the FMV of "such property." Although "property" can refer to assets in both the singular and plural, as used in the Regulation it appears to refer to all property contributed by the partner, not just the property with respect to which the expenditures were incurred. If the exception were applied property by property, it would be applicable in the example only to the extent of $24 (20% of the $120 FMV of land E) because the FMV of the property exceeds 120% of the $90 adjusted tax basis of the property. Reg. 1.707-5(a)(4), however, refers to "property or properties," suggesting applicability in the singular.
22. In the example, every dollar of boot received increases the amount realized by $2 (and, conversely, every dollar of qualifying reimbursement that otherwise would be disguised sale proceeds decreases the amount realized by $2), since the qualified liability equals half of the property's gross FMV. The higher the loan-to-value ratio, the larger the multiplier effect.
23. That portion is computed by multiplying the qualified liability by the net equity percentage. The qualified liability is $900 and the net equity percentage is $210 divided by $900.
24. A portion of this gain is attributable to Section 704(c) property contributed by C, as previously noted.
25. The apportionment of the gain among the three properties is based on the realized gain inherent in each of the properties.
26. In this scenario, only $30 of preformation expenditures would be reimbursed by OP.
27. Former Prop. Reg. 1.707-3(e) (PS-163-84, 4/25/91).
28. These rules should be contrasted with those applicable to Subchapter C transactions. For a corporate transferee, the consideration would be spread among all the assets pro rata based on the net FMV of the assets. See Rev. Rul. 68-55, 1968-1 CB 140. In addition, with respect to boot received in an otherwise tax-free corporate contribution under Section 351, gain but not loss would be recognized. Under Section 707(a)(2)(B), the receipt of boot triggers a disguised sale and resulting gain or loss. 29 Reg. 1.704-1(b)(2)(ii)(b)(2).
29. The Regulations describe two specific circumstances in which allocations will not satisfy the substantiality requirement. First, an allocation will not be substantial if, at the time it becomes part of the partnership agreement, there is a strong likelihood that the adjustments to the capital accounts will not differ substantially from the adjustments that would be made if the allocation in question were not in the partnership agreement, and the total tax liability of the partners will be less than the tax liability would be if the allocation in question were not in the partnership agreement. Reg. 1.704-1 (b)(2)(iii)(b). Second, an allocation will not be substantial if the partnership agreement provides for the possibility that an allocation will be largely offset by one or more other allocations and, at the time the allocation becomes part of the partnership agreement, there is a strong likelihood that the adjustments to the capital accounts of the partners will not differ substantially from the adjustments that would be made if the allocation in question were not in the partnership agreement, and the total tax liability of the partners will be less than the tax liability would be if the allocation in question were not in the partnership agreement. An allocation will not be insubstantial for purposes of this second circumstance if, at the time the original and offsetting allocations become part of the partnership agreement, there is a strong likelihood that the offsetting allocation will not, in large part, be made within five years after the original allocation is made. Reg. 1.704-1(b)(2)(iii)(c). Even if an allocation is not treated as insubstantial under these two circumstances, however, it still may fail to be respected under the basic rule described in the text.
30. The special allocation to A enables B and C to defer the recognition of their gain until they choose to sell the OP units.
31. If the capital accounts are adjusted on the liquidation of A's interest, the capital accounts would be increased by the gain that would be recognized if the partnership assets were sold for FMV. Reg. 1.704-1(b)(2)(iv)(f). This has the effect of allocating the recognized gain to A and the realized but unrecognized gain to B and C, as in the liquidation of the partnership.
32. Under Section 704(a), allocations must be made in accordance with the partnership agreement, unless another provision (such as Section 704(b) or (e)) mandates a different allocation.
33. A distribution of OP Units to B and C would result in a mandatory $book up$ under Reg. 1.704-1 (b)(2)(iv)(e).
34. The economic effect issue might be resolved in this circumstance by adjusting the capital accounts of all partners in connection with the liquidation of A's interest. This would cause a portion of the unrealized gain inherent in the OP units to be allocated to A, with the result that A's capital account would be increased to $300. As discussed in the text, however, the allocations of all of the recognized tax gain to A and all of the unrealized tax/recognized book gain to B and C resulting from the $book up$ may fail the substantiality test.
35. See, generally. Reg. 1.704-2(f). Partnership minimum gain is the gain that would be recognized if the partnership disposed of property subject to a nonrecourse liability for no consideration other than full satisfaction of the liability. Minimum gain is measured as of the end of the tax year. When property subject to a nonrecourse liability is sold, the partnership's minimum gain as of the end of the year generally will be reduced (compared with the gain as of the end of the prior year) because the partnership no longer owns the property. When minimum gain is reduced, the minimum gain chargeback requirement applies and each partner must be allocated items of partnership income and gain equal to the reduction in its share of minimum gain. If a partner previously was allocated nonrecourse deductions by the partnership, the partner will have a share of partnership minimum gain and the reduction in partnership minimum gain generally will trigger a chargeback allocation to that partner.
36. Assuming the form of a transaction structured as a transfer of partnership interests is respected, an issue exists as to whether a partner receiving a combination of cash and units from an OP may rely on the exception for reimbursements of preformation expenditures to shelter from tax a portion of the cash received, if the expenditures were incurred by the partnership rather than the transferring partner. Stated another way, should the aggregate or the entity theory of partnership taxation be applied for purposes of these rules? The Regulations provide the exception for capital expenditures "incurred by the partner." It is questionable whether this can be read as applying to the partner who did not incur the expense other than through an aggregate analysis. Reg. 1.707-4(d)(2).
37. Although the IRS provides that tax consequences will follow the form selected, a transaction not covered by one of the three forms (e.g., a rollup of a partnership into a corporation) presumably will be treated under the rationale of Rev. Rul. 70-239, 1970-1 CB 74, as a contribution of partnership assets to the corporation in exchange for stock to be distributed in liquidation of the partnership. Proposed Regulations allowing an elective change from partnership to association treatment under the check-the-box rules expressly provide that the change is to be treated as an asset contribution to the association followed by a liquidating distribution of association interests by the partnership. Prop. Reg. 301.7701-3(g)(1) (REG-105162-97, 10/27/97). Nevertheless, the Preamble to the Proposed Regulations states that they do not affect the holdings of Rev. Rul. 84-111, 1984-2 CB
38. See generally Pillow, Schmalz, and Starr, "Changing an Entity's Classification by Election: The First Modifications to Check-the-Box," 88 JTAX 143 (March 1998).
39. See, e.g., Rev. Rul. 68-289, supra note 2, Rev. Rul. 72-172, 1972-1 CB 265, and Rev. Rul. 99-6, supra note 2.
40. See, e.g., McCauslen, supra note 2, and Court Holding Co., 324 U.S. 331, 33 AFTR 593 (1945).
41. See, e.g., Reg. 1.741-1.
42. See McKee, Nelson, and Whitmire, Federal Taxation of Partnerships and Partners, Third Edition (Warren, Gorham & Lamont, 1996). ¶ 15.03[2].
43. Under Reg. 1.708-1(b)(2)(i), if two or more partnerships merge into one partnership, the resulting partnership is considered the continuation of the partnership the members of which own an interest of more than 50% in the capital and profits of the resulting partnership.
44. McKee et al., supra note 42, ¶ 12.06[1], footnote omitted, emphasis added.
45. There could be unforeseen results from this approach. For instance, assume that (1) A sells one-fourth of his interest for $75 and receives 225 units, (2) B and C receive 300 units each, and (3) the transaction is structured at the partner level. A successful Rev. Rul. 68-289 attack presumably would result in a deemed transfer of all the property to OP in exchange for 825 units and $75 of cash. This in turn gives rise to no gain at the partnership level due to the reimbursement rule. The distribution of cash to A would produce no gain so long as A had sufficient debt allocated from OP. Such a transaction would place the IRS in a difficult position. If the Service seeks to tax A based on the form of the transaction, it might undercut its position with respect to restructuring other transactions based on Rev. Rul. 68-289.
46. See Rev. Rul. 69-6, 1969-1 CB 104; Bittker and Eustice, Federal Income Taxation of Corporations and Shareholders, Sixth Edition (Warren, Gorham & Lamont, 1994), ¶ 12.22[1].
47. In Rev. Rul. 68-289 and its progeny, however, all partners in the target partnership owned interests in the acquiring partnership after the transaction and the sole consideration provided was partnership interests in the acquiring partnership.
48. It is unclear whether McCauslen was deemed to have acquired the property from his partner or the partnership.
49. Rev. Rul. 99-6 states that for purposes of determining the tax consequences of the purchasing partner, the partnership is deemed to make a liquidating distribution of all of its assets, following which the purchasing partner is treated as acquiring the assets deemed to have been distributed to his former partner. In contrast, the selling partner is treated as selling his partnership interest to the purchasing partner.
50. Rev. Rul. 73-427, 1973-2 CB 301, Rev. Rul. 74-565, 1974-2 CB 125, Rev. Rul. 79-273, 1979-2 CB 125.
51. To the extent the target partnership is immediately liquidated by OP, the transaction could be recharacterized as an acquisition of assets.
52. See note 40, supra. 53 For a more detailed discussion of this doctrine, see McKee et al., supra note 42, ¶ 15.03[2].
53. A negative capital account reflects a reduction in a partner's basis below its equity investment in the partnership, i.e., the negative account represents reductions in the portion of the partner's basis attributable to the partner's share of partnership debt. The repayment of the debt is treated as a constructive cash distribution to the partner equal to the portion of the debt previously included in his basis. Section 752(a). As a result, the partner will recognize gain to the extent his basis previously has been reduced below his share of the debt. This amount is equal to the negative capital account.
54. If OP chooses to use the remedial allocation method for a particular property contributed by the ABC partnership, there may be an additional share of debt allocated to the ABC partners under the second tier of Section 752.
55. See Rev. Rul. 95-41, 1995-1 CB 132, regarding the ability to include Section 704(c) built-in gain in excess of the Section 704(c) minimum gain in the determination of profits for purposes of third-tier allocations of debt.
56. It appears that this requirement should be treated as satisfied even if gain may be recognized as the result of the receipt of some boot because the units are acquired in a nonrecognition transaction.
57. Five years for property contributed before 6/9/97.
58. Reg. 1.737-2(b)(1).
59. Reg. 1.737-2(b)(2).
60. Under a factual setting that might be unusual for an UPREIT but which is quite common in other partnerships, a buyout for cash by OP of all the units technically could trigger gain to the OP under the rationale of Rev. Rul. 99-6. This could arise when OP owned an interest in the selling partnership that it received via a contribution of appreciated property. Under the Ruling, for purposes of determining the tax consequences to OP. the partnership is deemed to distribute its properties to all the partners, thereby potentially triggering a Section 704(c)(1)(B) gain with respect to OP.
61. Section 704(c)(1)(A).
62. See note 58, supra. 64 Section 704(c)(1)(B).
63. See note 58, supra. 66 Section 737.
64. See Sections 856(c) and (d).
65. Sections 7704(c) and (d).
66. Reg. 1.7704-1.
67. Section 1(h).
68. Section 168(i)(7).