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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   July 2005

Clear the hurdles of financing and like-kind exchanges

c_2005-07_Black_spotReal estate like-kind exchanges would be far simpler if they only involved the sale of relinquished property and the acquisition of replacement property without the issues raised by financing. However, that is much like asking a bus to stop at your front door when the bus stop is down the street. It might be convenient, but it’s not likely to happen.

Financing is the fuel of real estate. It increases returns from limited equity. But issues arise when using financing as part of an exchange. One issue is the segregation of money. To qualify for nonrecognition treatment under Section 1031 of the US Tax Code, the money used to purchase the replacement property must consist of proceeds received from the sale of the relinquished property. In other words, it must be clear that the proceeds are 1031 funds. Once that is determined, the financing may proceed. A simple way to think of it is to exchange first and subsequently finance the property. To ensure the validity of the exchange, it is essential to document the source of funds (1031 vs. financing).

Another issue is the taxpayer’s ownership of the relinquished and replacement properties. A critical requirement of like-kind exchanges is that the taxpayer must own the relinquished property and the replacement property. But a familiar criterion of current real-estate loans, especially in the capital-markets era, is the requirement that the title-owning entity be a special-purpose, bankruptcy-remote entity. These issues are managed through an appropriately structured, single-member, limited- liability company.

Single-member, limited-liability companies

Under the treasury regulations, state-law-entity classifications do not govern the treatment of entities. For this reason, a business entity with two or more owners can choose to be classified as either a partnership or an association for federal income tax purposes (and as an association, it is treated as a corporation). On the other hand, a business entity with only one owner may elect to be classified for federal income tax purposes as an association or an entity disregarded from its owner.

The default rule for a single-owner entity is that it is disregarded. The benefit of choosing disregarded treatment is that the assets and liabilities of the single-owner entity are treated as the assets and liabilities of the single owner. If the taxpayer in a like-kind exchange acquires the replacement property through a single-member, limited-liability company, it is as if the taxpayer alone acquired the property.

But lenders also require the borrower entity to be bankruptcy-remote. This requires a single-member, limited-liability company to be protected against the risk of dissolution of the sole member by the addition of another member. But with two members, the limited-liability company becomes either a partnership or an association. Under either classification, the 1031 taxpayer is not considered the owner, and the exchange fails.

Enter the springing member. A springing member — also known as a special member — is a member built into the operating agreement who has no economic interest in the limited-liability company. This member’s role is to ensure that the entity does not dissolve upon the removal or dissolution of the final economic member of the limited-liability company. After all, it’s not good for the lender if its borrower simply goes away. If the last-remaining economic member is removed or dissolved, the springing member remains a member of the limited-liability company to avoid dissolution. The springing member has no economic interest in the limited-liability company, so the company still is treated as having a sole owner and as a disregarded entity. This merges the requirements of bankruptcy-remoteness and 1031.

From the lender’s perspective, one problem with this structure is the concept of recourse. Even with a nonrecourse loan, a lender routinely wants more than just the empty shell created by a bankruptcy-remote, single-purpose entity. In most loans, the lender will pursue a guaranty for recourse carve-outs and a hazardous-substances indemnity.

Although this is an option, it is not optimal to enter into these obligations from a taxpayer’s perspective. The lender might want the party that executes the guaranty for recourse carve-outs and the hazardous-substances indemnity to be a parent of the borrower. Conversely, taxpayers may want to fix their liability for recourse carve-outs and hazardous substances.

The nature of disregarded single-member, limited-liability companies creates a solution. By inserting a single-member, limited-liability company between the borrower and the taxpayer in the ownership structure, the taxpayer creates a new entity in the chain of entity ownership. Because it is a single-member, limited-liability company, it will also be disregarded. The taxpayer maintains treatment as owner of the underlying real estate. This entity can be capitalized by cash, a letter of credit or even a promissory note in a fixed amount that the lender and taxpayer can accept.

Tenancy in common

Considering multiple-party ownership in a like-kind exchange context involving financing also brings into play structural considerations. More than one taxpayer can exchange into a single piece of real estate as part of a like-kind exchange. This arrangement is known as a tenancy in common (TIC). A TIC arrangement makes sense when it is best to purchase a more-costly property using multiple 1031 buyers. The Internal Revenue Service adopted Revenue Procedure 2002-22, which set guidelines for obtaining a private letter ruling with respect to a TIC structure. It ensures that the structure operates like real-property ownership instead of a partnership arrangement.

Therefore, in a TIC structure, property- management agreements cannot extend beyond a one-year period. In addition, decisions regarding management, leasing, sale and financing secured by a blanket lien on a property require unanimous approval. While owners under the revenue procedure are generally required not to have restrictions on transfer, partition and encumbering an interest in the property, these standard lending practices are permitted for TIC interests.

Structurally, most lenders and 1031 purchasers deal with these issues in exchanges by property acquisition through multiple single-member, limited-liability companies owned by each taxpayer. All of these taxpayers hold title to their own tenancy-in-common interest. As with traditional financings involving a single borrower, this arrangement permits the lender to institute a bankruptcy-remote, single-purpose entity structure while permitting the taxpayer to own the underlying real-estate interest for federal tax purposes because the limited-liability company itself is disregarded. The tenants in common enter into a TIC agreement. The agreement includes the revenue-procedure guidelines but also contains lender-appropriate restrictions, such as a waiver of the right to partition.

To exemplify this structure, let’s imagine that Al, Frank and Beatrice decide to acquire the Big Arena, each as a one-third tenant in common. They also are each acquiring their one-third interest as replacement property for their respective exchanges. They have chosen to use Large Lender as their financing source. Large Lender requires that the property be owned by bankruptcy-remote, single-purpose entities. So Al, Frank and Beatrice establish their own individual limited- liability companies. They then acquire their TIC interests in Big Arena through their respective limited-liability companies. The three limited-liability companies enter into a TIC agreement that requires unanimous consent for decisions involving management, leasing, financing and sale. Other decisions require a majority vote of the tenants in common. Each limited-liability company waives partition rights under the TIC agreement.

After completing the exchange by purchasing the TIC interests through their limited-liability companies, Al, Frank and Beatrice have each limited-liability company enter into the loan with Large Lender. The limited-liability companies are makers on the promissory note to Large Lender and join in executing the mortgage and loan agreement encumbering Big Arena. The mortgage contains traditional transfer restrictions and disallows further encumbering the TIC interests in the property. Properly structuring this transaction means that Al, Frank and Beatrice each have acquired an interest in Big Arena as part of a like-kind exchange while satisfying the critical requirements of Large Lender in entering the financing.

Developing situation

One development of note in the like-kind exchange, TIC market is the use of Delaware Statutory Trusts. Under Revenue Ruling 2004-86, the IRS allowed beneficial interests in a fixed-investment, grantor trust structured as a Delaware Statutory Trust-owning real estate to qualify for like-kind treatment to real estate as part of an exchange.

The ruling said that more than one party could acquire beneficial interests in the trust. This meant that fee-simple title in the property could be held by one entity structured as a Delaware Statutory Trust, while more than one party could purchase the underlying property as part of an exchange through acquisition of beneficial interests in the Delaware Statutory Trust.

The use of Delaware Statutory Trusts in TIC arrangements helps purchasers finance a property because it avoids the issues that ownership of the asset through multiple limited-liability companies creates. The revenue ruling is limited, however, and raises questions. Accordingly, the 1031 industry’s general understanding and acceptance of Delaware Statutory Trusts in the TIC arena is still in the embryonic stage.

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Like-kind exchanges can occur in a vacuum, but that kind of situation is rare. Financing is a frequent and essential part of many exchanges. Understanding the obstacles and successfully navigating them can substantially improve the economics of a transaction, while avoiding pitfalls.


 


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