Typically, commercial real estate or unimproved property is held in a multi-member limited liability company (“LLC”). Under this structure, the promoter of the investment is typically entitled to share with the investors the distributions made by the LLC once the investors have received a return of their capital and a specified internal rate of return. The popularity of this structure arises, in part, from various tax benefits such as the flow-through of depreciation deductions to the investors and long-term capital gain treatment to the promoter on distributions made by the LLC. However, one apparent short-coming of the structure from a tax perspective is the complexity that occurs upon a sale of the property if some investors desire tax-deferred like-kind exchange treatment and others desire to pay the tax arising from the sale and to cash out their investment.
One structure that we have seen commonly proposed in connection with a sale of a property where some, but not all, of the investors want like-kind exchange treatment is the so-called “drop and swap” structure. Under this structure the following occurs:
(i) The multi-member LLC deeds out the property from the LLC to its members (including the promoter) in the same proportion as the members would have received from the distribution of sale proceeds;
(ii) After the deed-out transfer, the members hold the property as co-owners under an arrangement intended to qualify as a tenancy-in-common (“TIC”) for purposes of the like-kind exchange rules of Section 1031 of the Internal Revenue Code; and
(iii) Upon the subsequent sale of the property, each co-owner elects separately whether to engage a qualified intermediary to hold the sale proceeds for use in a tax-deferred like-kind exchange or keep the proceeds and recognize the gain on the sale for tax purposes.
The “drop and swap” structure, in concept, appears to be a relatively simple real estate transaction. However, tax guidance issued by the IRS and various court cases indicate that a failure to follow certain formalities could prevent the parties from obtaining the desired tax treatment. Thus, prior to adopting a "drop and swap" structure, full consideration should be given to the potential tax risks that can arise in the structure.
Not All Co-Ownership Structures Work for Purposes of Satisfying the Like-Kind Requirement
Under Section 1031, the gain arising from the sale of real estate can be deferred if the disposition of the real estate is structured as a like-kind exchange which satisfies the conditions of Section 1031. Among these conditions is that the owner of the real estate acquire property that is of a “like-kind” to the relinquished property. Under this “like-kind” requirement, the disposition or acquisition of a membership interest in a LLC that is classified as a partnership for U.S. federal income tax purposes can never qualify as like-kind property. This is true even if the taxpayer uses the proceeds distributed to him by the multi-member LLC from the sale of the relinquished property to acquire an interest in a multi-member LLC that also owns real property.
For purposes of this rule, only multi-member LLCs are classified as partnerships for U.S. federal income tax purposes. In contrast, single member LLCs are typically classified as disregarded entities and not as partnerships for U.S. federal income tax purposes. Thus, this like-kind issue with respect to property held by LLCs will be of a concern only where the property-owning LLC has more than one member.
Example 1: Mr. White owns a 33 percent membership interests in WWW, LLC which owns a retail center in suburban Chicago. Assume that the retail center is sold while it is owned by WWW, LLC and that Mr. White uses his share of the sale proceeds to acquire all of the membership interest in another LLC that owns a different retail center. Because WWW, LLC and not Mr. White owned the property at the time of its sale, Mr. White will not be able to defer the gain arising from the sale by WWW, LLC under the like-kind exchange rules of Section 1031 even if all of the conditions set forth in Section 1031 can be otherwise satisfied.
Example 2: Same facts as Example 1 above except assume that prior to the sale of the retail center, WWW, LLC distributes the ownership interests in the retail center to Mr. White, Ms. Williams and Ms. Waters as co-owners and, after the distribution, Mr. White, Ms. Williams and Ms. Waters as co-owners sell the retail center. Assume that Mr. White uses his share of the proceeds to acquire a 100 percent membership interest in another LLC that owns a different retail center. Even though Mr. Williams did not own the relinquished retail center at the time of its sale through a multi-member LLC, there are some circumstances in which the Internal Revenue Service (the “IRS”) could re-cast the co-ownership structure as a partnership for U.S. federal income tax purposes. If the IRS determines that the co-ownership structure is to be classified as a partnership for U.S. federal income tax purposes, Mr. White will not be able to defer the gain arising from the sale of the relinquished retail center under the like-kind exchange rules of Section 1031 even if all of the conditions set forth in Section 1031 can be otherwise satisfied.
As described above, the structure in which a multi-member limited liability conveys its real property to its members to hold as co-owners prior to the sale of the property is typically referred to as a “drop and swap” structure. However, members of an LLC that are contemplating the use of a “drop and swap” structure must consider that if the co-ownership gets re-cast by the IRS as a partnership for federal income tax purposes, tax-deferred like-kind exchange treatment will not be allowed. As a result, members of LLCs contemplating the “drop and swap” structure must confirm that the co-ownership is properly structured for U.S. federal income tax purposes.
Reported tax cases indicate that in the context of examining whether a transaction satisfied this “like-kind” requirement, the IRS has succeeded in re-casting co-owner structures as partnerships for income tax treatment. See Luna v. Comm’r, 42 T.C. 1067 (1962); Comm’r v. Culbertson, 337 U.S. 733 (1949); Bergford. v. Comm’r, 12 F3d 166 (9th Cir. 1993). Based upon the holdings of these reported cases, a multi-factor test is generally used by the IRS to determine whether a co-ownership structure must be re-cast as a partnership for purposes of applying the like-kind requirement. These factors are often referred to by tax advisors as the “Luna Factors.”
In 2002, the IRS issued Revenue Procedure 2002-22 which set forth guidelines under which the IRS will issue a private letter ruling on whether a co-ownership TIC structure would be recast as a partnership for purposes of applying the like-kind requirement. The Revenue Procedure applies some, but not all, of the Luna Factors. In fact, Revenue Procedure 2002-22 includes factors in addition to the Luna Factors in these advance ruling guidelines.
It is important to note that Revenue Procedure 2002-22 clearly states that the factors set forth in the Revenue Procedure are not intended to be a substantive statement of tax law. In fact, in many of the private letter rulings issued by the IRS after the issuance of Revenue Procedure 2002-22, the IRS found like-kind exchange treatment even though some of the factors set forth in the Revenue Procedure were not satisfied. Thus, an examination of whether a co-ownership structure can be re-cast by the IRS as a partnership for purposes of the like-kind exchange should be based on the analysis applied by the courts in Luna, Culbertson and the other cases in which this issue has been examined and use Revenue Procedure 2002-22 only as a guidepost.
Issues to Consider in Structuring a “Drop and Swap”
In light of existing guidance on the relevant tax issues, parties considering a "drop and swap" structure should examine the following:
- Is there a formal written agreement which sets forth the rights and obligations of the co-owners?
Prior to the “drop and swap,” the governance rights of the members would be set forth in the operating agreement of the LLC that owned the property. After the conveyance of the property by the LLC to the co-owners, the parties would enter into a written tenancy in common agreement which sets forth the governance rights of the co-owners. One of the differences between the operating agreement and the tenancy in common agreement is that the same voting rights set forth in the operating agreement might not be permitted in a tax-compliant co-ownership structure. Specifically, both Revenue Procedure 2002-22 and the reported tax cases indicate that any decision to sell, refinance, or to enter into any loan will require the consent of all of the co-owners (i.e., unanimous consent). In addition, unanimous consent is required for leasing activities.
There are other requirements that will also have to be addressed in the co-owners' agreement such as the mechanics for hiring and firing the asset/property manager, exercising a right to partition, and how distributions are to be made. For example, distributions under a tax-compliant co-ownership structure, net of fees (at market rates), must be made solely in accordance with each co-owners' ownership interest. Thus, the inclusions of non-market fees or a non-pro rata distribution (e.g., to a promoter) will increase the tax risk that the co-ownership structure could be recast as a partnership.
- Is there a formal written agreement under which the co-owners have hired a party to operate the property and collect rents after the property has been deeded out to the co-owners?
Under both Revenue Procedure 2002-22 and the reported cases, there will be significant tax risk if one of the co-owners is given responsibility for collecting rents and operating the property. In other contexts, the activities of a multi-member LLC can be imputed to its members. Thus, if one of the members will act as the asset and property manager, the use of a corporation might reduce the risk that the co-ownership structure could be recast as a partnership for purposes of the like-kind requirement. In addition, under Revenue Procedure 2002-22, the term of any asset and property management agreement cannot exceed one year (but it can be subject to automatic annual renewal under certain circumstances). Thus, the existence of an asset and property management agreement between the co-owners and another party can reduce the risk that the co-ownership structure could be recast as a partnership for purposes of the like-kind requirement.
- Is the property operated in a manner that reflects the transfer of ownership from the multi-member LLC to the co-owners?
Even if the co-owners enter into a co-ownership agreement and an asset and property management agreement that addresses the requirements of a tax-compliant co-ownership structure, the co-owners will continue to face tax risk if the LLC continued to collect the rents and to oversee the operation of the property. For example, if, after the conveyance of the property by the LLC to the co-owners, the tenants continue to pay rent to a bank account of the LLC or if the leases are not assigned by the LLC to the co-owners, the co-owners will face increased risk that the co-ownership structure could be recast as a partnership for purposes of the like-kind requirement.
- Has the relinquished property been conveyed to the co-owners in the same manner as a third party conveyance would occur?
If the property owned by the multi-member LLC is subject to a mortgage and the loan documents require the consent of the lender for a transfer, a failure to record the conveyance or obtain lender consent could increase the risk that the co-ownership structure could be recast as a partnership for purposes of the like-kind requirement.
The date on which the conveyance of the property by the LLC to the co-owners could be viewed as a relevant factor in determining whether the “drop and swap” structure will be respect by the IRS. In addition to the like-kind requirement, the requirements for tax-deferred like-kind exchange treatment set forth in Section 1031 require that the exchanging taxpayer hold the relinquished property “for investment.” If the conveyance of the property by the LLC to the co-owners is not recorded until the moment before the sale of the property to a third party, the co-owners will face substantial risk that the IRS could conclude that the co-owners acquired their co-ownership interest in the property for purposes of immediately selling it rather than for investment.
While the “drop and swap” structure appears to be very straightforward, ignoring the mechanics required for a tax-compliant co-ownership structure could significantly increase the risk that the IRS could find that the co-owner failed to satisfy the “like-kind” requirement set forth in Section 1031. If the IRS concluded that the co-owner could not properly claim like-kind exchange treatment, the co-owner will be required to pay taxes on the gain arising from the sale of the relinquished property notwithstanding that the co-owner used the sale proceeds to acquire replacement property.
Having the “drop and swap” structure reviewed by a tax attorney who is familiar with the TIC structure and Revenue Procedure 2002-22 will provide the co-owner with an opportunity to minimize this tax risk and in some cases, the issuance of a tax opinion could help the co-owner avoid tax penalties should the IRS assert that notwithstanding the adoption of the “drop and swap” structure, the co-owner failed to satisfy the like-kind requirement.