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Disguised Sales, Mixing-Bowls and Synthetic Installment Sales. Howard E. Abrams habrams@taxnerds.com www.taxnerds.com. Disguised Sale of Property Definition. There must be a contribution of cash or property.
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Disguised Sales, Mixing-Bowls andSynthetic Installment Sales Howard E. Abrams habrams@taxnerds.com www.taxnerds.com
Disguised Sale of Property Definition • There must be a contribution of cash or property. • There must be a distribution of cash or property to the contributing partner. Either can come first. • The contribution and distribution, when considered together, properly are characterized parts of a single transaction.
“Properly Characterized” • Would the distribution not have been made but for the contribution? • If the contribution and distribution are not simultaneous, was the subsequent transaction dependent on the entrepreneurial risks of the partnership venture? • Were the contribution and distribution separated by two years or less? If so, strong presumption a disguised sale. If not, strong presumption not a disguised sale.
Notable Exceptions • Distributions of Operating Cash Flow. • Lesser of share of overall profits for current year and percentage of profits over life of the venture. • Safe harbor is lowest share of all material item of income over forward-looking three-year window. • Reasonable Guaranteed Payments for Capital. • Reasonable Preferred Returns. • Reimbursement of Preformation Expenditures. • Limited to 20% of the value of the property if the value of the property exceeds 120% of adjusted basis. • Disclosure required even though not a disguised sale.
Contributions of Encumbered Property • To the extent that debt shifts to other partners, there will be a simultaneous contribution and distribution. • Because the contribution and distribution are simultaneous, recharacterization as a disguised sale is automatic. • If the transaction is recharacterized in whole or in part as a disguised sale, it is treated as a sale for all purposes.
Which Debts Count? • “Qualified Liabilities” are ignored! • Old and cold debt (more than two years old); • Not incurred in anticipation of contribution; • Allocable to capital improvements made to the property under Reg. §1.163-8T; or • Incurred in the ordinary course of a trade or business and all the assets used in the trade or business are contributed to the partnership.
Contribution of Encumbered Property: Example • X Contributes Cash of $800,000 • Y Contributes Property • Value = $1,600,000 • Adjusted Basis = $900,000 • Debt = $800,000 • X and Y will be equal partners and the debt is fully nonrecourse.
Contribution of Encumbered Property: Example • $400,00 of Debt Is Shifted to X • Disguised Sale Fraction = $400,000/$1,600,000 • Basis Allocated to Sale = One-Quarter of $900,000, or $225,000 • Gain = $400,000 - $225,000, or $175,000 • Gain Affects Inside Basis and Outside Basis
What Might X Do? • Keep the liability. • Arrange for another contribution of encumbered property as part of the same transaction. When multiple contributions are made as part of the same transaction, nonqualified liabilities given up can be netted against nonqualified liabilities taken on. • Note the implication for joining a venture by forming a new, lower-tier partnership. This works if the existing partnership has nonqualified liabilities.
Recomputing the Sale Price • X contributes property to the P partnership with an adjusted basis of $10,000 and value of $100,000. $100,000 in cash is distributed to X one year later, and the contribution and distribution are treated as a disguised sale. • Implicit interest under section 1272 must be backed-out of the sale price for the one-year deferral. If $10,000 is the proper interest component, then X has sold 90% of the property at a taxable gain of $81,000.
Keeping the Other Partners Neutral • In this deferred sale example, the partnership will be entitled to an interest deduction of $10,000. How should it be allocated? • Had there been no disguised sale, there would be no interest deduction. To preserve the economics of the transaction, the interest deduction should be allocated entirely to the contributing partner so that the other partners are unaffected by the disguised sale.
Deferred Sale Example • X and Y form the XY partnership, with X contributing Blackacre with adjusted basis of $60,000 and value of $100,000. Y contributes cash of $50,000. Subsequently, the cash is distributed to X. • Case 1: No disguised sale. • Case 2: Disguised sale, deferred interest equals $2,000, no special allocation of interest. • Case 3: Disguised sale, deferred interest equals $2,000, special allocation of interest.
Case 1: No Disguised Sale • ___________X___________ __________Y___________ • Capital Basis Capital Basis • $ 100,000 $ 60,000 $ 50,000 $ 50,000 • ( 50,000) ( 50,000) 0 0 • $ 50,000 $ 10,000 $ 50,000 $ 50,000 • Note that capital accounts are equal, showing that each partner has contributed $50,000 to the venture.
Cases 2 and 3: Disguised Sale • First, the numbers: • If there is a $2,000 interest component out of the $50,000 deemed paid by the partnership, then the principal amount deemed paid equals $48,000 (48% of fair market value). • If 48% of the property is deemed sold, then 52% (worth $52,000) is treated as contributed. • Of the partner’s $60,000 adjusted basis in the property, 52% (or $31,200) is allocable to the contributed portion of the property and 48% (or $28,800) is allocable to the sold portion. • The disguised sale gain thus equals $48,000 less $28,800, or $19,200.
Case 2: Disguised Sale, No Special Allocation • ___________X___________ __________Y___________ • Capital Basis Capital Basis • $ 52,000 $ 31,200 $ 50,000 $ 50,000 • ( 1,000) ( 1,000) ( 1,000) ( 1,000) • $ 51,000 $ 30,200 $ 49,000 $ 49,000 • Note that capital accounts no longer are equal, giving X a dominant interest in the venture.
Case 3: Disguised Sale With Special Allocation • ___________X___________ __________Y___________ • Capital Basis Capital Basis • $ 52,000 $ 31,200 $ 50,000 $ 50,000 • ( 2,000) ( 2,000) 0 0 • $ 50,000 $ 29,200 $ 50,000 $ 50,000 • Note that capital accounts again are equal, showing that each partner has contributed $50,000 to the venture.
Preformation Expenditures Problem • X owns unimproved real estate with adjusted basis of $400,000 and fair market value of $2,000,000. X improves the property by constructing a building at a cost of $2,500,000, increasing the value of the property to $5,000,000. Can X contribute the property and get reimbursed for the construction costs? • No! The maximum tax-free reimbursement is $1,000,000 because the value of the property exceeds 120% of its adjusted basis ($5M as compared with $2.9M).
Preformation Expenditure Solution • Construct the building with borrowed funds. Then contribute the building subject to the debt. The debt will be a “qualified liability” because it is allocable, under the rules of Reg. § 1.163-8T, to capital improvements. • Note that there is no related party limitation, so that the debt can be borrowed from an affiliate so long as the the form of the loan will be respected.
Revenue Ruling 2000-44(October 10, 2000) P S Liability of $40 on 1/1/2005 Capital Improvement of $5 on 12/1/2008 Real Estate
Revenue Ruling 2000-44(October 10, 2000) P S S merges into P under §332 on 1/1/2009 Liability of $40 on 1/1/2005 Capital Improvement of $5 on 12/1/2008 Real Estate
Revenue Ruling 2000-44(October 10, 2000) P Liability of $40 on 1/1/2005 Capital Improvement of $5 on 12/1/2008 Real Estate
Revenue Ruling 2000-44(October 10, 2000) Issue: Can P qualify for the exceptions to the disguised sales rules for qualified liabilities and preformation expenditures? P P contributes the real estate to PRS on 1/1/2010 PRS Liability of $40 on 1/1/2005 Capital Improvement of $5 on 12/1/2008 Real Estate
Revenue Ruling 2000-44(October 10, 2000) Holding: Yes, P takes on the identity of S for applying the disguised sales rules. P P contributes the real estate to PRS on 1/1/2010 PRS Liability of $40 on 1/1/2005 Capital Improvement of $5 on 12/1/2008 Real Estate
Taxation Under Section 704(c)(1)(B) __________X_________ __________Y__________ CA OB CA OB $ 50,000 $ 40,000 $ 100,000 $ 100,000 0 10,000 0 0 5,000 0 5,000 0 0 0 ( 60,000) ( 50,000) $ 55,000 $ 50,000 $ 45,000 $ 50,000 Book Value Inside Basis X’s Asset $ 50,000 $ 40,000 Y’s Asset 100,000 100,000 X’s asset is distributed to Y within 7 years of contribution when it is worth $60,000.
Avoiding Section 704(c)(1)(B) • Contractually lock-in contributed property for as long as possible. • Permit dispositions that are tax-free. • Require that if contributed property is transferred to a lower-tier partnership, the transferee is bound by the same rules.
Depreciable Property and Remedial Allocations • P Contributes cash of $10,000 to the PQ partnership while Q contributes property with value of $10,000 and adjusted basis of $4,000. The property contributed by Q is depreciable. Q has 5 years remaining on the property’s recovery period; if the property were newly-placed in service, its cost would be recovered over 12 years. • Using the remedial allocation method, there is book depreciation of [$800+500 or] $1,300 for years 1-5 and $500 for years 6-12 while there is tax depreciation of $800 for years 1-5 only. • P and Q agree to be equal partners.
Creating a de Facto Installment Sale Seller owns depreciable property with value of $100 and adjusted basis of $20 recoverable over next 4 years; property generates $8.00 on annual income. Buyer is willing to pay cash of $100 for property; new recovery period will be 40 years.
