For years, real estate investors have enjoyed the benefits of tax deferral under Section 1031 of the Internal Revenue Code (“1031 Exchange”). Under the 1031 Exchange rules, sellers of U.S. real estate are able to defer some or all of the capital gains tax on sales proceeds which are re-invested in replacement properties identified and purchased within particular timeframes after the date of the sale. But what if some of the seller’s members prefer to pocket their share of the sales proceeds (and pay the resulting capital gains tax) rather than re-investing those funds in a replacement property? One approach is to implement a like-kind exchange with a note structure (“1031 Note Transaction”).
Role of the Qualified Intermediary
In a typical 1031 Exchange, a qualified intermediary (“QI”) holds the cash proceeds received from the buyer of the relinquished property until they are re-invested in one or more replacement properties. This is done in an effort to prevent the cash proceeds from being characterized as taxable “boot” income to the seller. However, in a 1031 Note Transaction: (1) the QI takes receipt of the cash proceeds from the sale; (2) a portion of the cash proceeds is set aside and used to purchase the replacement property; (3) the remainder of the cash proceeds is retained; and (4) a promissory note is issued to and in favor of the seller in an amount equal to such remainder of the cash proceeds (“Remainder Note”).
Redemption
Following the sale of the property, those owners of the seller entity who wish to receive their share of the sale proceeds (“Cashout Investors”) are redeemed out of the seller entity. To effect the redemption, the Remainder Note is distributed to the Cashout Investors. If the seller is a partnership or a limited liability company, a new partner or member may need to be admitted to the seller entity so that it remains a partnership for federal income tax purposes. Accordingly, the partnership agreement or operating agreement of the entity should be amended to reflect the exit of the Cashout Investors and, to the extent necessary, the admission of a new partner or member.
Remainder Note
For income tax purposes, payments made pursuant to a Remainder Note must be treated as an installment sale covering two taxable years of the seller. Accordingly, those Cashout Investors who receive the Remainder Note in redemption of their interests will receive their redemption payout over two tax (i.e., calendar) years. For example, if the seller entity sells a property in December of 2020, each Cashout Investor may receive a portion of the sales proceeds in December of 2020, with the balance to be collected in 2021.
Conclusion
A 1031 Note Transaction can be a viable method for allowing certain owners of an entity selling U.S. real estate to undertake a 1031 Exchange while allowing other owners to collect their share of the sale proceeds. However, the particulars of any 1031 Exchange are fact dependent, and the rules governing 1031 Exchanges continue to evolve. A property owner must consult with capable tax and real estate counsel before undertaking a 1031 Note Transaction.
For more information about 1031 exchange options, please contact Andrew Maguire (amaguire@mkbattorneys.com, 610-341-1032).
Please note that this article does not constitute legal advice or tax advice, and that reading this article does not create an attorney-client relationship with McCausland Keen + Buckman.