A 1031 Exchange Adventure!
A client of mine found itself in an interesting situation. The client was a family limited partnership that held a property (actually a ½ undivided interest) in a 3200 square foot store in a prime West Hollywood location. The basis, dating back to a death in 1966 was $22,500. The client’s half of an unsolicited offer of over $6 million came to about $3million. . The rental income produced an average of $40,000 to $72,000 per year to this one-half undivided interest in the property.
Gen 1 (parents) formed the family limited partnership as part of their estate plan. According to the estate plan, when the last of the Gen 1 parents (of the 9 Gen 2 limited partners) passed away, the family limited partnership’s assets were to be distributed to the extent possible in liquidation. This created the following problem: How to distribute a one-half undivided interest in a single rental property to 9 individual partners. It appeared that for the foreseeable future, the partnership would have to continue renting the property and incurring all the attendant costs of running a partnership, filing tax returns, etc.
At the time the offer was received, Gen 1 partners were in their 90’s. This windfall created an early liquidation opportunity, but the tax bite would exceed $1.5 million.
This property was ripe for a 1031 exchange to defer the gain of about $3 million and push the tax of over $1 million off to a later date! The problem was….what to buy for the up leg? Another store?, an apartment building?
In a few years, it was a virtual certainty that the partnership would once again have one rental property to divide 9 ways when Gen 1 passed away.
The family, a long – time client, asked me to come up with a strategy that accomplished the tax free exchange and accommodated the planned distribution of the estate upon their passing.
My solution was simple in concept, but complex to execute. The $3million in proceeds split 9 ways comes to about $330k each……enough to buy a single family residence. I proposed a plan to acquire 9 or 10 single family homes which we would then rent to create a residential real estate portfolio that could be divided among the 9 limited partners (Gen 2) upon the last Gen 1 death. We would then have the various rental properties appraised on the date of the last death of gen 1 general partners, then distribute the rental properties to the various limited partners in complete liquidation of the partnership. There were adequate cash reserves to equalize the value differentials if I kept the average price between $300k and $400k per house.
Essentially, I was hired as a fiduciary to manage the entire 1031 exchange transaction from sale, to purchase, to rent up of the properties, an engagement that took me about one year through rehab and rent-up of the 10 up leg properties.
Gen 1’s wish was to hold and the property and the income, then let Gen 2 (nine limited partners in the partnership) distribute the estate equally. Naturally, when you have 9 individual partners, you have various different agendas. Some would love to have the cash proceeds, pay the tax and use or invest the rest. Some would rather just have the rental income.
The original offer of $7.4 million came in July, 2014 and called for a 60 day escrow. The buyer was using this as an up leg to another 1031 exchange. Over the course of 6 months we carried out very difficult negotiations with this very difficult buyer (a foreign developer). Over that time, the price was reduced to a more realistic $6.2 million.
Before the offer, the family had a one-half undivided interest in a property with 9 other Gen 2 individual owners from another side of the family. The property was leased to a tenant who was negotiating hard for reduced rent and other concessions. Without this sale, the family was facing either a rent concession or a vacancy that could last 6 months plus whatever improvements to suit a new tenant might cost. Shortly before the sale, the lease was up and we negotiated a month-to month lease with the tenant with a 60 day notice clause and encouraged him to find a new location. The net rent to the partnership was about $72,000 per year at that point.
After the exchange, this rental portfolio is generating about $120,000 in net cash flow to the partnership annually and it no longer has a “single property” exposure, but has 10 producing assets spread over 3 states. Of course, the management piece is significantly greater, but is handled by paid professionals. Also, the nature of a residential rental is such that unless the residence is trashed by a tenant, the rent-up period and related costs (vs. TI’s in the case of a commercial rental) are much lower. Given the probable liquidation date, this strategy, as complex as it was, greatly facilitates the eventual distribution of the estate to the nine members of Gen 2. To a tax professional like me, it’s downright elegant!
The only way I could accomplish this engagement and have so much fun doing it was with the help of other professionals. Andrew Zimbaldi, Broker and Rich Wordes, attorney coordinated and quarterbacked the sale transaction between a very difficult buyer and a total of 10 individual sellers. I was truly grateful that the half I represented was in a partnership requiring only one signature!
Inside our firm, Stefan Massy and Robyn Manley were invaluable assistants. Also, a shout out to my partner, Don and the rest of the team for putting up with my frequent absences while looking at properties during our busiest season of the year.
Through my friend, Kathy Canfield of Meridian Properties, I was able to acquire 3 properties in Tennessee which greatly help overcome the low rent to value rates we see in Southern California. These three properties generate about 10% annual return. Partners #7 and 9 found me rentals in their locale, Paul Colucci, Jonathan Mann and Aaron Evans helped me find local properties and manage them for me, and finally CB&T banker, Bob Whitelaw and Exchange “Accommodator Extraordinaire” Kelly Pearl who made the acquisition of properties very easy indeed!
All of you helped make this one of the greatest accomplishments of my nearly 40 year career. Many Thanks!