A Primer on the Disguised Sale Rules and the Exception for Reimbursed Preformation Expenditures
January 27, 2022
A contribution of cash or other property by a partner to a partnership in exchange for an interest in the partnership is generally not a taxable transaction. Normally, the partnership will take a carryover basis in the contributed cash or property equal to the adjusted basis of such money or property in the hands of the contributing partner at the time of transfer, and the partner will take a carryover basis in their partnership interest. Distributions of cash and/or property from a partnership to a partner generally reduce the basis of the partner’s interest in the partnership; such distributions are generally not taxable to the partner unless the amount of cash distributed exceeds the partner’s basis in its partnership interest (as measured immediately prior to the distribution). If property is distributed by the partnership to a partner, the partner will generally take a carryover basis in the distributed property equal to the partnership’s adjusted basis at the time of distribution (to the extent of the partner’s remaining basis in their partnership interest); such distribution will reduce the recipient partner’s adjusted basis in their partnership interest by the amount of adjusted basis that the partner takes in the distributed property.
What happens if…?
- A partner contributes appreciated property to a partnership in exchange for a partnership interest, and then immediately takes a distribution of cash from the partnership?
- In substance, the partner can be viewed as having sold the appreciated property to the partnership.
- A partner contributes cash to a partnership, and then the partnership distributes appreciated property to the partner?
- In substance, the partnership can be viewed as having sold the appreciated property to the partner.
- One partner contributes appreciated property to a partnership, another partner contributes cash to the same partnership, and then the partner that contributed property receives a distribution of the cash that was contributed by the other partner, and the partner that contributed the cash receives a distribution of the property that was contributed by the first partner?
- In substance, one partner can be viewed as having sold appreciated property to another partner.
- A partner who owns appreciated property gets a mortgage on such property, keeps the cash, and transfers the property to a partnership (which takes the property subject to the debt)?
- In substance, the partner received consideration from the partnership in the form of liability assumption.
The ability to combine contributions and distributions to achieve the economic substance of a sale without triggering the tax consequences of such a sale led Congress to enact the disguised sale rules, which were designed to combat the use of partnerships as a vehicle to transfer appreciated property from one taxpayer to another taxpayer without triggering the recognition of gain.
Disguised Sale Rules Defined
Under the statute, if there is a direct or indirect transfer of money or other property by a partner to a partnership, and there is a related direct or indirect transfer of money or other property by the partnership to such partner (or another partner), and the transfers, when viewed together, are properly characterized as a sale or exchange of property, the disguised sale rules will effectively treat the transfers as a deemed sale of property between the participating taxpayers.
Under the Treasury Regulations, to the extent that a taxpayer contributes property (other than money) to a partnership, and a transfer of money or other consideration (including the assumption of a liability and/or taking the property subject to a liability) is made to such partner, the transaction will be treated as a sale of such property (in whole or in part) to the partnership if, (1) based on the facts and circumstances, the transfer or money or other consideration would not have been made but for the transfer of property, and (2) in cases where the transfers are not made simultaneously, the subsequent transfer is not dependent on the entrepreneurial risks of partnership operations.
If the transfer of property and the transfer of money and/or other consideration are made within two years of each other, the transaction is presumed to be a disguised sale unless the facts and circumstances clearly establish that the transfers do not constitute a sale. Conversely, if the transfer of money or other consideration and the transfer of the property are more than two years apart, the transfers are presumed not to be a sale of the property unless the facts and circumstances clearly establish that the transfers constitute a sale.
To the extent that cash or other consideration is treated as proceeds from a disguised sale, the amount of cash and consideration received in relation to the fair market value of the property at the time of transfer is the percentage of the property that was deemed to be sold to the partnership.
The term “disguised sale” can often be a misnomer. Sometimes, the parties to a disguised sale fully intend for the transaction to be treated as a sale. Often, the owner of appreciated property may simply be looking for a partner and may wish to partially cash out some of their own equity, while remaining an indirect partial owner of such property through a newly formed partnership. These scenarios are treated under the disguised sale rules as partial sales (in the form of cash proceeds) and partial contributions (in the form of rollover equity in the partnership).
Example 1: partial disguised sale and a partial contribution of property to a partnership:
Assume that a taxpayer transferred a building with a fair market value of $1,000,000 and an adjusted basis of $700,000 to a partnership, in exchange for an interest in the partnership, and then within two years, such partner received cash or other consideration in the amount of $450,000 from the partnership, the partner will generally be deemed to have sold 45% of the building to the partnership for $450,000, and contributed 55% of the building to the partnership in exchange for a partnership interest valued at $550,000. The partner will be able to offset the $450,000 sales proceeds with 45% of such partner’s adjusted basis of $700,000, and then will recognize a gain in the amount of $135.000 on the partial sale of 45% of the building to the partnership. The partner’s remaining basis of $385,000 (representing 55% of such partner’s original $700,000 adjusted basis) will be deemed to be contributed to the partnership in exchange for a partnership interest valued at $550,000.
Impact on Transfer Subject to Liabilities
As mentioned previously, sometimes “other consideration” can take the form of liability assumption by the party to whom the appreciated property is transferred. The transferee either assumes the liability directly or takes the property subject to such liability. When viewed through a partnership lens, the net effect of such assumption is that the transferor is no longer 100 percent liable for repayment of the debt; to the extent that their share of the liability is reduced, the net reduction may be viewed as “other consideration. For example, if a partner transfers a building with a fair market value of $1,000,000 (subject to a mortgage of $8,000,000) to a partnership in exchange for a 50% partnership interest, 50% of the liability assumed by the partnership is viewed as having been transferred to the other partner(s). The transferor has a reduction of $4,000,000 in his liability, upon assumption by the partnership.
The regulations provide that all liabilities assumed (or taken subject to) by the partnership fall into two categories: “qualified liabilities of the partner” and “liabilities of the partner other than qualified liabilities”. A qualified liability is any liability assumed by the partnership, or where property is taken subject to such liability, that was either (1) incurred more than two years prior to the transfer or (2) acquisition debt, the proceeds of which were used to acquire and/or improve the property. Conversely, any liability assumed by the partnership (or where property is taken subject thereto) that does not meet the definition of a “qualified liability” is a nonqualified liability. Nonqualified liabilities are treated as disguised sale proceeds with respect to such property transferred to the partnership, to the extent that such contributing partner’s share of such liabilities are reduced as a result of the transfer. In other words, the net reduction in the contributing partner’s nonqualified liabilities is treated as being transferred to the other partners and is therefore treated as consideration to such partner.
Example 2: nonqualified liabilities assumed by partnership:
Suppose that the partner in the first example who transferred the building with a fair market value of $1,000,000 to the partnership had incurred a $800,000 mortgage one year prior to the transfer. Assume that none of this debt was used to acquire or improve the property. Since this liability had been incurred within the two-year period immediately preceding the transfer of the property and was not “acquisition debt”, it does not meet the definition of a qualified liability. Immediately after the transfer of the building to the partnership, the partnership distributes $150,000 to the partner (intended as partial sale proceeds) and issues a 10% partnership interest valued at $50,000 to such partner. Also assume that the partner’s adjusted basis in such transferred property at the time of transfer was $700,000.
Since the partner will have a 10% interest in the partnership after the transfer, the partner is deemed to retain 10 percent of the $800,000 mortgage and therefore, the $720,000 reduction in his liability is treated as additional proceeds.
The partner will have total disguised sale proceeds of $870,000 which represents 87 percent of the $1,000,000 fair market value of the building. The partner will be able to offset these deemed sale proceeds with 87 percent of its $700,000 basis at the time of transfer. The partner will therefore recognize a gain in the amount of $261.000 on the disguised sale of the building to the partnership.
The result is that the partnership will have purchased basis of $750,000 in the building. The partnership will have contributed basis from the partner in the amount of $175,000 (representing 25% of the partner’s $700,000 adjusted basis). The contributing partner will have a basis of $175,000 in its partnership interest.
In contrast, only a portion of qualified liabilities are treated as disguised sale proceeds to the contributing partner. The amount that must be treated as a transfer of consideration to such partner is the lesser of (i) the amount of consideration that the partnership would be treated as transferring to the partner if the liability were not a qualified liability; or (ii) the amount obtained by multiplying the amount of the qualified liability by the partner’s net equity percentage with respect to that property. The net equity percentage is the percentage determined by dividing the aggregate transfers of money or other consideration to the partner (that are treated as proceeds from the sale of the transferred property) by the excess of the fair market value of the property over any qualified liabilities encumbering the property. For example, if a partner transferred a building with a fair market value of $1,000,000, subject to a mortgage encumbering such building in the amount of $800,000, the excess of the fair market value over the qualified liability encumbering it would therefore be $200,000. If the partner transferring such property received $150,000 of aggregate cash and other consideration, the net equity percentage would be 75 percent.
Example 3: qualified liabilities assumed by partnership:
Suppose that the partner in the first example who transferred the building with a fair market value of $1,000,000 to the partnership had an $800,000 mortgage that had secured the building for the previous three years. Since none of this liability had been incurred within the two-year period immediately preceding the transfer of the property, it meets the definition of a qualified liability. Immediately after the transfer of the building to the partnership, the partnership distributes $150,000 to the partner (intended as partial sale proceeds) and issues a 10% partnership interest valued at $50,000 to such partner. Also assume that the partner’s adjusted basis in such transferred property at the time of transfer was $700,000.
To determine the percentage of the $800,000 qualified liability that must be treated as disguised sales proceeds, the amount of cash proceeds ($150,000) must be compared to the $200,000 net fair market value of the property (i.e., the $1,000,000 gross fair market value of the building, less the $800,000 mortgages assumed). The amount of qualified liabilities assumed is the lesser of (i) the $800,000 qualified liability multiplied by the ratio (i.e., 75 percent) of the $150,000 cash proceeds relative to the $200,000 net fair market value transferred, or (ii) the 90 percent portion of the $800,000 qualified liability transferred to other partners (i.e.., the amount that would be treated as consideration by the partner if the liability were not a qualified liability). Since 75 percent of the qualified liability (i.e., $600,000) is less than the 90 percent of the $800,000 qualified liability that is deemed to be transferred to other partners (i.e., $720,000), only $600,000 of the qualified liability will be treated as disguised sale proceeds, in addition to the $150,000 cash proceeds to be received by the partner.
The partner will have total disguised sale proceeds of $750,000 which represents 75 percent of the $1,000,000 fair market value of the building. The partner will be able to offset these deemed sale proceeds with 75 percent of its $700,000 basis at the time of transfer. The partner will therefore recognize a gain in the amount of $225.000 on the disguised sale of the building to the partnership.
The result is that the partnership will have purchased basis of $750,000 in the building. The partnership will have contributed basis from the partner in the amount of $175,000 (representing 25% of the partner’s $700,000 adjusted basis). The contributing partner will have a basis of $175,000 in its partnership interest.
Other Cash Received Such as Reimbursement of Preformation Expenses
There are four exceptions where partner can receive cash or other consideration from a partnership, where the receipt of such cash or consideration will not be treated as sales proceeds: (1) reasonable guaranteed payments for the contributing partner’s use of capital; (2) reasonable preferred returns for the contributing partner’s use of capital; (3) operating cash flow distributions; and (4) reimbursements of preformation expenditures (within certain prescribed limitations). It is the fourth exception that will be the focus of this article.
It is not uncommon for taxpayers to purchase property that they intend to own in partnership with other investors; sometimes, they must close on such property before they are able to line up the other intended equity. There are also a multitude of situations where the owner of appreciated property must make significant capital expenditures to maintain or improve such property, with the intent of transferring such property to a new partnership where new equity will be invested by another partner. Treasury provided an exception for preformation expenditures, which would allow the partner that incurred such capital expenditures prior to transfer of the property to a partnership, to be reimbursed by the partnership for such expenditures within certain limits.
A transfer of money or other consideration by the partnership to a partner is not treated as part of a sale of property by the partner to the partnership to the extent that the transfer to the partner by the partnership is made to reimburse the partner for capital expenditures that were incurred during the two-year period preceding the transfer by the partner to the partnership. In order to qualify for this exception, such capital expenditures must have been incurred by the partner with respect to partnership organization and syndication costs, or property transferred to the partnership by the partner (but only to the extent that the reimbursed capital expenditures do not exceed 20 percent of the fair market value of such property at the time of transfer to the partnership. However, this 20 percent limitation does not apply if the fair market value of the transferred property does not exceed 120 percent of the partner’s adjusted basis in the transferred property at the time of transfer.
Example 4: disguised sale where the 20-percent of fair market value limitation applies:
Suppose that the partner in the previous example who transferred the building with a fair market value of $1,000,000 to the partnership had incurred $250,000 of capital expenditures during the two-year period immediately preceding the transfer of the property. Immediately after the transfer of the building to the partnership, the partnership distributes $250,000 cash to the partner (intended as a reimbursement of such partner’s preformation capital expenditures) and $200,000 cash intended as partial sale proceeds. Also assume that the partner’s adjusted basis in such transferred property at the time of transfer (including the $250,000 of capital expenditures previously made) was $700,000. Because the fair market value of the building ($1,000,000) exceeds $840,000 (120 percent of the partner’s $700,000 adjusted basis), the partner can be reimbursed up to $200,000 (i.e., 20 percent of the building’s $1,000,000 fair market value), and such reimbursement will not be treated as disguised sale proceeds. Therefore, the partner can exclude $200,000 of the $450,000 cash received from being treated as sales proceeds.
The remaining $250,000 (which represents 25 percent of the $1,000,000 fair market value of the building) will be treated as disguised sale proceeds. The partner will be able to offset the $250,000 deemed sale proceeds with 25 percent of its $700,000 adjusted basis. Therefore, the partner will recognize a gain in the amount of $75,000 on the deemed sale of 25% of the building to the partnership. The partner will be deemed to contribute the remaining 75% of its $700,000 basis, or $525,000, to the partnership in exchange for a partnership interest. Then, the $200,000 cash that was excludible from the $250,000 intended reimbursement will be treated as a distribution from the partnership to the partner, which will reduce such partner’s basis by $200,000.
The result is that the partnership will have purchased basis of $250,000 in the building. The partnership will have contributed basis from the partner in the amount of $525,000 (representing 75% of the partner’s $700,000 adjusted basis). The contributing partner will have a basis of $325,000 in its partnership interest (after reduction for the $200,000 distribution that was deemed to be a reimbursement of its preformation capital expenditures).
Example 5: disguised sale where the 20-percent of fair market value limitation does not apply:
Suppose that the partner in the previous example who transferred the building with a fair market value of $1,000,000 to the partnership had incurred $400,000 of capital expenditures during the two-year period immediately preceding the transfer of the property. Immediately after the transfer of the building to the partnership, the partnership distributes $400,000 cash to the partner (intended as a reimbursement of such partner’s preformation capital expenditures) and $50,000 cash (intended as partial sale proceeds). Also assume that the partner’s adjusted basis in such transferred property at the time of transfer (including the $400,000 of capital expenditures previously made) was $850,000. Because the fair market value of the building ($1,000,000) does not exceed $1,020,000 (120 percent of the partner’s $850,000 adjusted basis), the partner can be reimbursed for all $400,000 of the preformation expenditures incurred within the two years preceding the transfer, and such reimbursement will not be treated as disguised sale proceeds. Therefore, the partner can exclude $400,000 of the $450,000 cash received from being treated as sales proceeds.
The remaining $50,000 (which represents 5 percent of the $1,000,000 fair market value of the building) will be treated as disguised sale proceeds. The partner will be able to offset the $50,000 deemed sale proceeds with 5 percent of its $850,000 adjusted basis. Therefore, the partner will recognize a gain in the amount of $7,500 on the deemed sale of 5% of the building to the partnership. The partner will be deemed to contribute the remaining 95% of its $850,000 basis, or $807,500, to the partnership in exchange for a partnership interest. Then, the $400,000 cash that was excludible will be treated as a distribution from the partnership to the partner, which will reduce such partner’s basis by $400,000.
The result is that the partnership will have purchased basis of $50,000 in the building. The partnership will have contributed basis from the partner in the amount of $807,500 (representing 75% of the partner’s $850,000 adjusted basis). The contributing partner will have a basis of $407,500 in its partnership interest (after reduction for the $400,000 distribution that was deemed to be a reimbursement of its preformation capital expenditures).
These limitations must generally be applied on a property-by-property basis. Furthermore, if the capital expenditures were funded by the proceeds of a “qualified liability” that a partnership assumes or takes property subject to in connection with a transfer of property to the partnership by a partner, a transfer of money or other consideration by the partnership to the partner is not treated as made to reimburse the partner for such capital expenditures to the extent the transfer of money or other consideration exceeds the partner’s share of the qualified liability immediately after the transfer.
Example 6 disguised sale where the 20-percent of fair market value limitation applies:
Suppose that the partner in example 3 who transferred the building with a fair market value of $1,000,000 (subject to $800,000 of qualified liabilities) to the partnership had incurred $250,000 of capital expenditures during the two-year period immediately preceding the transfer of the property. Further assume that $100,000 of such capital expenditures had been funded by qualified liabilities that are being assumed by the partnership
Even though the liabilities are “qualified liabilities”, 90 percent of the partner’s liability is being reduced upon assumption by the partnership (because the partner will own 10% of the partnership after the transfer); therefore, the partner will still be considered indirectly liable for 10% of the $800,000 liability.
Immediately after the transfer of the building to the partnership, the partnership distributes $250,000 cash to the partner (intended as a reimbursement of such partner’s preformation capital expenditures) and $200,000 cash intended as partial sale proceeds. Also assume that the partner’s adjusted basis in such transferred property at the time of transfer (including the $250,000 of capital expenditures previously made) was $700,000. Because the fair market value of the building ($1,000,000) exceeds $840,000 (120 percent of the partner’s $700,000 adjusted basis), the partner can be reimbursed up to $200,000 (i.e., 20 percent of the building’s $1,000,000 fair market value), and such reimbursement will not be treated as disguised sale proceeds. Therefore, the partner can exclude a maximum of $200,000 of cash received from being treated as sales proceeds.
However, $100,000 of the $250,000 preformation expenditures had been funded by qualified debt, and 90% of such qualified debt was effectively transferred to the other partners upon assumption by the partnership. Therefore, 90% of the $100,000 amount of qualified debt that funded the $250,000 of preformation expenditures is not reimbursable under the preformation expenditures exception. Therefore, the preformation capital expenditure amount of $250,000 must be reduced by the $90,000 amount that was funded by qualified liabilities that is effectively being transferred to the other partners; only $160,000 is therefore eligible to be excluded.
The remaining $290,000 (which represents 29 percent of the $1,000,000 fair market value of the building) will be treated as disguised sale proceeds. The partner will be able to offset the $290,000 deemed sale proceeds with 29 percent of its $700,000 adjusted basis. Therefore, the partner will recognize a gain in the amount of $87,000 on the deemed sale of 29% of the building to the partnership. The partner will be deemed to contribute the remaining 71% of its $700,000 basis, or $497,000, to the partnership in exchange for a partnership interest. Then, the $160,000 cash that was excludible from the $250,000 intended reimbursement will be treated as a distribution from the partnership to the partner, which will reduce such partner’s basis by $160,000.
The result is that the partnership will have purchased basis of $290,000 in the building. The partnership will have contributed basis from the partner in the amount of $497,000 (representing 71% of the partner’s $700,000 adjusted basis). The contributing partner will have a basis of $337,000 in its partnership interest (after reduction for the $160,000 distribution that was deemed to be a reimbursement of its preformation capital expenditures).
In summary, the disguised sale rules are complex and can have very disparate results, depending on how they are structured. The exception for preformation expenditures can be a powerful deferral technique if proper planning is undertaken. Taxpayers need to be aware of these rules and should consult their tax advisors prior to engaging in one of these transactions.