The Partnership Installment Note Method
Given our recent blog post on partnership issues in 1031 exchanges, we want to continue with this same general topic. Here we’ll discuss a closely closely topic: the partnership installment note method for dealing with unwilling partners. There are a number of ways to deal with a partner that doesn’t want to participate in a 1031 exchange. The two most common approaches, the drop and swap, and the swap and drop, are complex transactions. Both must be structured extremely carefully; otherwise there’s a considerable risk of audit failure.
Both the drop and swap and the swap and drop approaches enable members of a partnership to accomplish specific goals. These two approaches can still have undesirable tax consequences, however, depending on their structure. We’re going to examine one way to avoid these negative consequences. The method in which the only the exiting member incurs a tax consequence is the “partnership installment note” method, Another common name for it is a PIN transaction.
PIN transactions are mechanically complicated. They can be extremely useful, though, because they dispel uncertainty regarding tax treatment. These types of transactions allow the partnership entity to remain intact, so they transactions can be thought of as variations of the swap and drop. In a PIN transaction, the exiting member can depart from the partnership prior to the exchange, and often does. In this post, we discuss the mechanics of partnership installment note transactions and highlight its advantages. Under the right circumstances, this method is a highly desirable way to deal with an exiting partnership member.
Receipt of Partnership Installment Note as Payment
The key advantage of the PIN method is that it avoids gain being recognized by all members of a partnership. Instead of receiving cash boot directly from the underlying exchange transaction, the departing member receives a note from the buyer of the relinquished property. That member trades his or her ownership stake in the partnership for this note. After the 1031 exchange has been completed, the buyer of the relinquished property will make payments directly to the member who exited the partnership. Again, this avoids the other partners from receiving cash boot and paying taxes on whatever gain they recognize from the distribution. Remember, partnerships, like S corporations, are pass-through entities. Accordingly, if the partnership received cash boot directly from the buyer, then all of the members would receive a portion of it, consistent with their entity ownership percentage.
PIN methods require a cooperative buyer willing to make payments to the exiting member of the partnership. For that reason alone, they can be difficult to structure and arrange. But if a cooperative buyer can be found, and the underlying financials make sense, the method can be very valuable.
Receipt of Funds and Tax Treatment
If the partnership were to receive cash from the exchange, all of the members receive taxable income. Additionally, there might also be double taxation when the members proceed to “buy out” the ownership stake of the nonparticipating member. Without a note, a taxable transaction will occur (or possibly occur, depending on his or her basis in the partnership) when the participating members buy out the interests of the non-participating member. This will take place after the taxable boot is received. Hence, PIN transactions gives certainty to the question of what tax consequences follow from the exchange. When the departing member receives the income due from the note, this will be taxable to that partner. In contrast, without the note, there will be more complexity and uncertainty regarding the tax consequences of the transaction.
Partnership Installment Note Example
Let’s look at a quick example. Suppose a partnership has three members and owns a piece of real estate valued at $300,000. Two members wish to conduct an exchange. The third member wants to cash out. Each members owns 1/3 of the partnership, so each has a 1/3 undivided ownership of the real estate. In this situation, if the partnership sells the property and receives $100,000 cash directly from the exchange in order to cash out the exiting member, all partners will be taxed on the cash boot.
Boot is considered to be a taxable distribution. In the above example, there might also then be a taxable transaction when the exiting member sells his interest. By utilizing the PIN method, however, the buyer simply transfers a note for $100,000 to the departing member, that member pays taxes on the income received, and reports that income under the installment method.
The partnership installment note method has an added benefit. It allows the partnership entity itself to remain intact following the transaction. As a result, the entity can both perform the exchange and then continue to indefinitely hold the replacement property. This avoids any potential holding period issues. It also carries less risk and causes less of a headache because there is no longer any need to dissolve the partnership and distribute new ownership interests in the real estate.
New York Tax Attorneys to Assist You
This overview services as a good introduction to PIN transactions. In order to get a sense of how complex they can be, though, it’s necessary to review a specific transaction in detail. Suffice to say thoug, PIN transactions can produce desirable outcomes for all involved. The professionals at Mackay, Caswell & Callahan, P.C., work diligently to master the ins and outs of complicated transactions. That way, we bring the best possible counsel to our clients. PIN transactions, like other transactions we’ve covered, can be complex and perhaps overwhelming for those unfamiliar with them. Accordingly, we do our best to explain their complexities as easily and plainly as possible. If you have a tax or business law issue, reach out to a top New York City tax attorney here at the firm. We’ll do what we always strive to do: provide straight talk and effective solutions.
Image credit: Mike Cohen