Tax-Deferred Cash Out
Separating Partnership Interests
A CPA contacted us with this scenario. His client was in a real estate investment that had appreciated greatly in value, and the owners agreed it was time to sell. However, the two owners had different exit goals. The CPA's client wanted a cash exit, while the other partner desired to exchange into other investment real estate.
The problem was that, in an exchange, the parties that relinquish the real estate in the exchange also must be the same parties that take title to the replacement property.
In some cases, owners of real estate who face this dilemma are advised to engage in a "drop and swap," which is a technique we do not recommend, because it can face resistance from tax authorities.
We suggested to the CPA that his client consider a tax-deferred cash out to resolve the problem arising from the two owners' differing exit objectives.
The tax-deferred cash out would be set up to occur contemporaneously with the sale of the property to a third-party buyer, which the sellers would line up in the usual way.
The CPA's client, who wants the cash exit, uses the tax-deferred cash out in this way. He sells his interest in the property to a dealer, who provides the seller with a 30 year installment sale contract, with interest-only payments and a balloon payment due after 30 years. This will defer the capital gains tax for this seller for 30 years.
The dealer will immediately resell the partial ownership interest in the property to the other owner, for cash.
The other owner obtains the cash needed to effect this sale by timing the transaction to occur simultaneously with the ultimate sale of the property to a third-party buyer through the exchange process.
The CPA's client obtains a loan from a third-party lender (introduced by us). This loan provides tax-free cash at closing to the CPA's client equivalent to 93.5% of net proceeds stated in the installment sale agreement with the dealer. The loan terms mirror those of the installment sale agreement -- interest only payments and a balloon payment of principal at the end of 30 years.
The owners agreed that this strategy would work for them.
After the combined transactions closed (the 1031 exchange and the tax-deferred cash out between the owners) then the following results were achieved:
The CPA's client received 93.5% of the net sales proceeds from the sale of his interest in the property to his partner. This money was received at closing and is tax-free cash that can be invested without restriction. So instead of just doing a cash sale, he did a tax-deferred cash sale.
Through the tax-deferred cash out, the other owner was able to (briefly) acquire 100% ownership of the property, enabling him to properly conclude a 1031 exchange, deferring his tax and leaving him with ownership of a replacement property.
In summary, a tax-deferred cash out can be used to separate partners who have different exit goals when selling highly appreciated real estate. One party can exchange into other real estate, tax-deferred, while the other can exit with 93.5% of their net sales proceeds in freely investable cash, tax-deferred for 30 years.