Commercial Property Owner

Selling The Building

“Five Guys and a Fifty Million Dollar Office Building” is not an episode of The Apprentice, but there certainly was enough drama created to air on reality television.

For twenty years these savvy real estate investors owned, renovated, leased and re-renovated their office building. Every decision from manual versus touchless bathroom faucets to asphalt versus concrete parking lots required a “meeting.” Critical input, over time, became snide comments. It got personal. Through the years, they began to refer to it as, “The Building.”

The day arrived when the toxic quintet wanted, probably needed, to part ways. Sell the building and split the profits, each to his own undivided interest.

The Dilemma

Commercial Property and 1031 Exchanges - Real Property 1031 ExchangeStraight-line depreciation and the Modified Accelerated Cost Recovery System (MACRS) had been used to provide tax advantages. Cost segregation studies uncovered ideal deductions that could be passed through the Limited Liability Company (LLC)1 structure of ownership. Debt was used to purchase the building and each owner was responsible for his portion. The mortgage on the building was just under $20 million.

Among the five gentlemen, there had been two divorces and one bankruptcy in the past twenty years. Each time a life event occurred, new paperwork was created to hold the LLC together. The lender on the property merged in year ten. More paperwork ensued. Baling wire and duct tape could be seen in the building’s basement. Not a single partner wanted to put more cash into “The Building.” The top priority was to sell. This was the only point of contention upon which all partners agreed.

They named their LLC, Venture One. They had known each other for years and considered themselves among “the well-bred, the well-fed, the well-read and the well-wed.” The LLC was composed of two fraternity brothers, their real estate lawyer’s nephew-by-marriage, a college buddy whose dad was wealthy and the young banker someone met at BNI2. From day one, each partner seemed anxious to buy, fix and rent every building in town. That was then. There would be no Venture Two.

The banker called first. He was brief. “We want out of the partnership, we want to sell, it’s 77% rented, it’s ‘as is,’ and we need to sell,” he quipped with a tempo of rapid staccato. He could not be bothered with the details, nor did he answer any detailed questions. Patrick, the attorney who drew up the LLC, listened. He knew each member, individually. He also knew them collectively. He was familiar with the gibberish, but this time it sounded as if the partners might all be on the same page. Patrick recalled a realtor who was looking at a similar building, so he agreed to set a meeting.

Each requested a separate meeting. The frat brothers agreed to meet at Starbucks if their schedules lined up. The others wanted to come, separately, to the attorney’s office. No group meetings and, most telling, no one wanted to meet in the lobby of Venture One for a walk-through of The Building.

The fraternity brothers needed to preserve their capital. Paying the least amount of taxes was of paramount importance to them. The rest wanted out. Period.

If ever there was a candidate for the “drop and swap3,” it was Venture One.

Drop & Swap

Under IRC § 1031(a)(2)(D), partnership interests are not exchangeable. The challenge here is to allow members to go their separate ways while not deeming them attempting to trade in their capacities as members.

While there are multiple ways to structure transactions allowing various members to effectively trade their interest, by far the most common technique is for the outgoing member to have the LLC redeem the member’s interest and to convey, by deed, the applicable percentage interest in the property equivalent to the member’s former share. The transfer to the member and the subsequent trade by that person is generally referred to as a “drop and swap.”

When the majority of members wish to cash out, the taxpayer can transfer his membership interest back to the LLC in consideration of his deed receipt for a percentage fee interest in the property equal to his former membership interest. Historically, a common solution was for the taxpayer to then own a tenant in common4 (TIC) interest in the relinquished property together with the LLC. At closing each would provide his deed to the buyer and direct his share of the net proceeds to a qualified intermediary (QI).

At times, the majority of members will wish to complete an exchange and one or more minority members will wish to simply cash out. The drop and swap can be used in this instance also by dropping applicable percentages of the property to the members who exit while the limited liability company completes an exchange at the LLC level and the former members cash out and pay the taxes due.

The Breakup

So, Patrick began the paperwork. Since the frat brothers owned 60% of Venture One, they simply kept the LLC. The remaining forty percent was dispersed as undivided interests among the other three partners.

The “held for” rule did not apply to those wanting to “cash out.” The terms “held” and “hold” in the law do not define a time period, but define intent. A taxpayer doing an exchange must have had the intent to hold the property. Time is one of many ways to prove intent. If a property is held for a period of a year, then it is fairly clear that the intent was to hold an investment property.

The Math of The Sale

The Building sold for $50 million and the closing looked like this:

Equity Debt
Fraternity Brother #1 $10,230,000 $6,270,000
Fraternity Brother #2 $8,370,000 $5,130,000
Daddy’s boy $6,200,000 $3,800,000
Patrick’s nephew $3,100,000 $1,900,000
Banker $3,100,000 $1,900,000

All the debt was paid to the lender at closing. The equity for the frat brothers went to the QI in the name of the entity, Venture One. The basis in the property was not unbearably low, but the depreciation recapture created a significant tax burden. Each of the three departing partners relinquished his percentage ownership using a TIC. They received their respective equity, paid the aggregate $4,000,000 in taxes and put The Building behind them.

The fraternity brothers found a DST with a 47% loan-to-value ratio5 (LTV) which, under IRS exchange rules, matched equity to equity and debt to debt. The non-recourse loan6 inside the DST allowed them to erase all personal liabilities from their balance sheets and control 17% more real estate than before.

The DST cap rate7 created a potential monthly income of $77,500 and no more Venture One. As an added feature, the frat bros deferred $6,000,000 in taxes.

Complex Real Estate 1031 Exchanges – Free Consultation

When you have commercial real estate for sale, give us a call or schedule a free consultation. Our experience could be beneficial to you and your partners.

The client example provided is for illustration purposes only and does not guarantee the same outcome for all. Individual results may vary depending upon their siltation. Past performance is not a guarantee of future results.
Numerical figures are approximate and for illustration purposes. Names have been changed in this example.

2BNI is a franchised networking organization. Members meet to discuss business and share referrals.
3Term used to describe the process of dropping out of a partnership or membership interest of a limited liability company (LLC) into an ownership interest in investment real estate and then exchange or swap for new investment real estate.