Using a PIN (Partnership Installment Note) or Buyout Around a 1031 Exchange

The money flow at closing: cash to the intermediary, the buyer’s note to the partnership, the note to the partner

Asset Preservation describes the PIN as ‘the conversion of the cash intended to go to cash-out partners into an installment note’, and insists on one condition: ‘The note must come from the buyer of property.’ The sequence below is what the purchase contract, the exchange agreement and the operating agreement have to authorise before closing.

• The purchase contract prices the property at $3,000,000, payable $2,000,000 in cash at closing and $1,000,000 by the buyer’s promissory note, secured by a deed of trust if the buyer’s lender permits.
• The partnership assigns its rights under the contract to the qualified intermediary, and the note is drawn so that it comes through the intermediary rather than being paid to the partnership directly.
• At closing the $2,000,000 is wired to the intermediary’s exchange account and the note is delivered; the partnership has received like-kind exchange rights plus one item of other property.
• The partnership distributes the note to the departing partner in complete liquidation of his interest under an amended operating agreement, and he becomes the holder.
• The buyer pays the note on its schedule; Asset Preservation notes that payments typically run ‘until the beginning of the year following the closing’, which is what makes the sale an installment sale.
• The intermediary uses the $2,000,000 to acquire the replacement property the partnership identifies within 45 days and closes within 180 days.

Worked example with round numbers: who reports $700,000, who defers $1,400,000, and in which year

Hypothetical: the partnership’s adjusted basis is $900,000, so the realised gain is $2,100,000, and each of the three equal partners has an outside basis of $300,000. The $1,000,000 note is the partnership’s only boot, and because §453(f)(6) excludes like-kind property from ‘payment’ and reduces the contract price by it, the gain attributable to the note is reported under the installment method rather than at closing.

When the note is distributed, §732(b) gives the departing partner a basis equal to his $300,000 outside basis, so collecting $1,000,000 produces $700,000 of gain to him, in the year the buyer pays. Reg. §1.453-12 orders that gain: ‘the unrecaptured section 1250 gain is taken into account before the adjusted net capital gain’, so the 25 percent portion is reported first and the 15 or 20 percent portion after it.

The two continuing partners keep their $1,400,000 share of the gain deferred inside the replacement property the partnership buys with the $2,000,000, and the replacement must cost at least that much to avoid a second layer of boot. A December closing with a January payoff moves the departing partner’s tax into the following year, the straddle covered in our guide on selling late in the year.

Why the note is not boot to the partners who stay: §731, §732 and the installment-obligation regulation

Three provisions carry the deferred boot gain out of the entity along with the note. §731(b) provides that ‘no gain or loss shall be recognized to a partnership on a distribution to a partner of property, including money’, and Reg. §1.453-9(c)(2) confirms that the disposition rule for installment obligations does not apply to ‘distributions by a partnership to a partner under section 731 (except as provided by section 736 and section 751)’.

Because the distributed note takes a §732(b) substituted basis instead of a fair-market-value basis, the $700,000 of built-in gain follows it to the departing partner; Asset Preservation summarises the result as gain on the note being ‘allocated solely to cash-out partners’. The partnership’s Form 8824 still shows the note as other property received, and its Form 1065 for the sale year should, in Legal 1031’s words, ‘reflect the restructuring of the partnership’.

Had the buyer paid the $1,000,000 in cash at closing instead, the partnership would have received money, §731(a)(1) would still shelter the distribution, but the gain on the cash boot would be recognised by the partnership in the year of sale and shared under the partnership agreement rather than carried out on a note.

Where a PIN breaks: buyers who will not carry paper, thin equity, hot assets and the §453A interest charge

The buyer has to agree to pay part of the price later, which many purchasers and most of their lenders resist; a short-dated note that matures in the first weeks of the next tax year is the usual compromise. Asset Preservation also rules the structure out where cash-out partners ‘hold high partnership percentages or property has high debt-to-equity ratios’, because the mortgage is repaid from the cash portion and a large note may not fit within the remaining equity.

§453(i) requires ‘any recapture income’ under §1245 and §1250 to be ‘recognized in the year of the disposition’, so accelerated depreciation on personal-property components taken in a cost-segregation study cannot ride on the note. The §736 and §751 carve-outs in Reg. §1.453-9(c)(2) mean payments to a retiring partner and partnerships holding unrealised receivables or inventory need a separate analysis.

§453A adds interest on the deferred tax only when the sales price exceeds $150,000 and the face amount of installment obligations arising in the year and outstanding at its close exceeds $5,000,000, so a $1,000,000 note paid off early in the next year stays clear of it.

PIN versus the simpler buyouts: cash at closing, a refinance after the exchange, or a pre-sale TIC deed

Each buyout route moves the same $700,000 of gain to a different taxpayer or a different year. The PIN wins when the contract is already signed and the departing partner accepts payment a few weeks after closing; the alternatives are compared in our guide on an exchange when only one partner wants cash.

• Cash boot at closing: the partnership recognises the gain in the sale year and, absent a valid special allocation, every partner reports a share of it, but the departing partner is paid at the table.
• Refinance after the exchange: no boot and no note, but the entity must first reinvest 100 percent of the net proceeds and the buyout waits on a new loan that the departing partner does not control.
• TIC deed before the sale: the departing partner sells his own undivided interest for cash and reports his own gain, which requires a distribution well before any contract and a lender willing to consent.
• PIN: gain confined to the departing partner and deferred until payment, at the cost of buyer cooperation, a note document and the recapture and §453A checks above.

Documents to settle before the purchase contract is signed

Because the note is created by the sale contract itself, the PIN cannot be added at the closing table. Line up the items below with your CPA and a tax attorney, who should confirm the §453 and subchapter K treatment for your partnership’s own facts.

• Purchase contract terms for the note: amount, interest at an adequate stated rate, maturity in the following tax year, security and prepayment rights.
• Operating agreement amendment permitting an in-kind distribution of the note and the complete redemption of the departing partner.
• Exchange agreement and assignment drafted so the note passes through the intermediary, preserving Reg. §1.1031(k)-1(j)(2)(iii) treatment.
• Final Schedule K-1 for the departing partner, Form 7217 for his receipt of the note, and Form 6252 to report his installment gain as payments arrive.
• Form 8824 for the partnership showing the note as other property, and a replacement property identification that reinvests the full $2,000,000.
• Replacement options ready before day 45: we can place the continuing partners’ proceeds into DST or triple-net interests from vetted national sponsors while the departure is being papered.