In New York City, rent-stabilized multifamily properties are going through a significant adjustment due to the rent regulations enacted in June 2019. While owners of non rent-stabilized multifamily properties are not currently affected by the new rent regulations, there may still be an indirect impact on such owners, as multifamily investors may prefer to acquire properties outside the rent-regulated area. Notwithstanding such impact, as multifamily properties in New York City and throughout the Northeast have enjoyed many years of significant appreciation, it’s likely that these owners will incur considerable capital gain taxes should they decide to sell.
Section 1031 provides a powerful tax deferral solution for multifamily owners to defer paying these capital gain taxes. Multifamily owners should be aware they may be faced with special challenges and unique 1031 exchange issues. In order to best structure and proceed with a successful 1031 exchange, owners should become familiar with these issues. Some of these special issues are outlined below.
Identifying the Tax Owner
Many multifamily owners own property in single member LLCs that are disregarded for federal tax purposes. These entities are generally set up and named to reflect the address of the property owned for practical reasons. For example, a multifamily apartment building located at 695 East 21st Street, New York, New York (which would technically be located in the East River!) might be titled in the name of 695 East 21 LLC. While 695 East 21 LLC is on title to the property, the filer of the tax returns for the LLC (and the tax owner) would be its sole member if 695 East 21 LLC is a disregarded entity and its sole member regarded (files a tax return). In this case, the sole member is 695 East 21st Street Associates, a New York partnership, which files the tax returns for the property. For purposes of a 1031 exchange, the partnership, 695 East 21st Street Associates, is the exchanging entity, and all documents will be drawn in the name of the exchanging entity.
Ownership Structure
695 East 21st Street Associates is the exchanging entity and, after 20 years of ownership, would like to sell the property and perform a 1031 exchange. The partnership has 20 partners. The partnership in the name of 695 East 21 LLC has signed a contract to sell the property for $30 million. While preparing for closing, the partnership is advised that partners owning approximately $5 million of the property wish to cash out and not be included in the 1031 exchange. How can payment of such $5 million be accomplished without interfering with the 1031 exchange?
Several options may be available to the partnership, the discussion of which is beyond the scope of this article and must be reviewed with legal and tax advisors. Examples include: (a) using funds not from the proceeds of the sale to redeem such partners’ interests, including funds raised from new investors, (b) using proceeds from the sale to redeem the interests of liquidating partners resulting in the partnership performing a partial, as opposed to full, exchange, (c) using a partnership installment note to pay liquidating investors what is due to them and (d) performing a partial drop-down to liquidating investors of their interests in the property. All of these options may involve risks which must be discussed with the partnership’s tax advisors, preferably well in advance of signing any contract but definitely in advance of closing.
Avoiding Boot
When a multi-family property is sold, typically certain amounts are credited against the purchase price. Examples are security deposits, pre-paid rents and other pro-rations and repair costs. However, doing so in a 1031 exchange could generate boot (defined as cash or other property added to an exchange to make the value of the traded goods equal) as the seller has, in effect, treated the security deposits and other operating costs as part of the buyer’s consideration for the property. At closing, this cash is in the seller’s hands and does not pass to seller’s qualified intermediary to be used in the exchange. This is boot, plain and simple.
That result could be avoided by having the seller bring such security deposits and other non-exchange expenses to closing or by the seller paying such sums to the buyer outside of closing. In the case of a credit for repairs, a seller may prefer to reduce the purchase price for the property to reflect the cost of the repair. The characterization of exchange expenses and closing costs in an exchange is a complex area and should be analyzed by a qualified tax professional before closing to avoid potential boot.
Title to Replacement Property
Once the sale of relinquished property has occurred, the exchanger has specific time periods in which to acquire all replacement property. Contracts for replacement property will only qualify if the buyer is the same tax owner as that selling the relinquished property. Using the previous example, this doesn’t mean that the replacement property contract buyer must be 695 East 21 LLC, but only that the tax owner of whoever is named as the buyer be 695 East 21st Street Associates, the partnership which sold the relinquished property. Thus, the exchanger is free to form a new single member LLC named to reflect the replacement property address to acquire and take title to the replacement property as long as it is disregarded and its sole member is 695 East 21st Street Associates. There are other forms of disregarded entities, but the single member disregarded LLC is the one most commonly used.
Pamela A. Michaels, Esq., is senior vice president with Asset Preservation Inc., a leading national 1031 exchange qualified intermediary. She can be contacted at 866-317-1031 or pamela@apiexchange.com.
