Partner Buyout With a Cash Out DST: Funding the Exit Before the Sale

The buyout must be funded before the sale, because exchange proceeds cannot pay a partner

Once the property closes, the sale proceeds sit with the qualified intermediary, and Reg. section 1.1031(k)-1(g)(6) requires the exchange agreement to deny the partnership any right to receive, pledge or borrow against that money before the exchange period ends, apart from narrow exceptions. Cash released to pay a partner is cash the partnership received, which is boot.

That leaves three families of solutions. The departing partner can take its share at closing after a drop of tenancy-in-common interests, covered in one partner wants cash; it can be bought out with an installment note, covered in PIN and buyout structures; or the partnership can raise the money itself before the sale and redeem the interest. This page is about the third route and why a cash out DST pairs with it.

The redemption keeps the partnership as the same taxpayer from start to finish, as long as at least two partners remain. If only one owner would remain, the taxpayer question changes, so check the same-taxpayer rules with your CPA before you choose this route.

How the redemption is taxed: the departing partner pays, the partnership does not

Payments that liquidate a retiring partner's interest fall under section 736, and the cash portion for the partner's share of partnership property is a distribution. Under section 731(a)(1) the partner recognizes gain only to the extent money distributed exceeds the basis of its interest, and section 752(b) adds the partner's released share of partnership debt to that money.

In practice the departing partner reports roughly its share of the built-in gain, and section 751 can recharacterize part of it as ordinary income. Section 731(b) says the partnership itself recognizes no gain on distributing money, so the remaining partners owe nothing at this step; their shares of the new loan rise instead.

Whether to refinance shortly before a sale is a timing question your CPA should clear; refinance timing around a 1031 sets out the considerations. The buyout gives the refinance its own purpose, and the loan documents and partnership minutes should show it.

The refinance creates a debt-replacement problem that a high-leverage DST is built to solve

Reg. section 1.1031(d)-2 treats liabilities you are relieved of as money received. Debt relief can be offset by debt on the replacement property or cash you add, but cash you receive cannot be offset by taking on debt. A partnership that refinanced to fund a buyout has a bigger mortgage to pay off at closing, so it must buy more property or carry more debt to defer fully.

Buying a single financed property for that much debt is slow and lender-dependent. The client describes its cash out DSTs, also called zero cash flow DSTs, as triple-net leased to investment-grade tenants on long-term leases, financed with non-recourse debt often in the 80 to 90% range, so that a small portion of exchange proceeds solves the debt requirement and frees the rest for low-leverage investments.

The rest can go into traditional DSTs, which the client describes as stabilized, professionally managed property with minimums typically between $100,000 and $250,000 per trust, or into a property the partnership buys directly.

Worked model: three partners, one leaves, two exchange

Hypothetical round numbers. An LLC owned equally by A, B and C holds a building worth $3,000,000 with a $600,000 mortgage and a $900,000 adjusted basis. A wants out. Months before listing, the LLC refinances to $1,400,000, repays the old loan and uses the $800,000 net to redeem A. A reports gain of about $700,000, one-third of the $2,100,000 built-in gain.

The LLC, now owned by B and C, sells for $3,000,000, pays off $1,400,000 and sends $1,600,000 to its intermediary. To defer fully it needs at least $3,000,000 of replacement property and $1,400,000 of replacement debt.

• Cash out slice: $250,000 into a cash out DST at a hypothetical 85% leverage buys about $1,667,000 of property carrying about $1,417,000 of debt.
• Income slice: the remaining $1,350,000 goes into traditional DSTs, assumed debt-free here.
• Totals: about $3,017,000 of property and $1,417,000 of debt, both above what was given up, so no boot.
• Without the cash out slice, a debt-free $1,600,000 allocation leaves $1,400,000 of unreplaced debt relief, and the LLC would recognize gain up to that amount.
• Run your own numbers with your CPA; leverage, fees and closing costs will change every line.

What B and C give up on the cash out slice: income, a fixed exit date and simplicity

The client states that cash out DSTs pay no monthly income, because all operating income services and amortizes the debt, and that value comes back through a refinance and the eventual sale. Repaying principal is not deductible, so the trust's taxable income can exceed what it distributes; the zero cash flow DST explainer shows how that phantom income builds.

The client says that after the DST's refinance an investor can receive 80 to 90% of its exchange value as cash, which B and C could use for other investments. Its pages give no date or guarantee for that refinance, and Rev. Rul. 2004-86 bars a DST trustee from refinancing, so the offering documents must explain how it happens, often through a springing LLC conversion.

The loan is non-recourse, so B and C risk their invested equity rather than their credit. High leverage magnifies losses if the tenant fails or values fall, and the client itself says the structure suits investors comfortable without current income. Size the slice to the debt, not to the whole exchange.