Consider the following situation: A developer and its investor partner form a venture to develop and lease a building. Now the building is substantially leased and stabilized, and the investor wants to cash out. The developer, on the other hand, desires to maintain its ownership share and retain the leasing and management work for the long haul. To achieve this, the developer locates a new investor who wants to invest in the stabilized asset.

Here's where the quandary begins. The developer and the new investor could form a new venture that would purchase the building from the existing venture. But this would result in taxable gain to the existing venture. Even though the developer is retaining an interest in the building, it would, as a member of the selling venture, be allocated its share of the taxable gain.

To avoid this, the new investor could purchase the interest of the existing investor, and the terms of the new venture would then be amended to reflect the business deal between the new investor and the developer. Only the existing investor would recognize taxable gain on the sale of its interest.

While this approach solves the developer's tax issue, it raises another. The new investor is typically reluctant to enter an existing entity that has potential liabilities resulting from its development and ownership of the building. As a condition to its investment, the new investor will generally require that the building be transferred by deed to a new venture that has no significant risk of historical liabilities.

This is the dilemma: the new investor requires the building to be transferred to a new venture, but the transfer to a new venture requires the developer to recognize taxable gain.

Merger Offers Solutions

Regulations finalized last year by the IRS have resolved this dilemma. These regulations (Section 1.708-1(c)(4)) recognize the economic reality of the situation described above, and permit the transfer of the building to the new venture without recognition of tax by the developer.

Here's how the regulations can work in practice. To accommodate the new investor, the existing venture transfers the building to a new venture in which the new investor and the developer are partners. All of the cash proceeds of the sale are distributed to the old investor, who treats the transaction as a sale of its interest in the existing venture and recognizes taxable gain. The existing venture is then liquidated.

It is critical that these aspects of the transaction are structured so that the transaction, for tax purposes, is treated as a merger of the existing venture into the new venture.

Since the new venture has acquired title by a deed transfer, it generally takes the title free of any historical liabilities affecting the existing venture. But for tax purposes, the transaction is treated as a merger of the old and new ventures, and the developer is treated as having exchanged its interest in the old venture for its interest in the new venture — without recognizing taxable gain.

Consequently, though the transfer is a sale under applicable state law, it is treated as a non-taxable merger for tax purposes. The regulations take a common-sense approach, and permit the developer, who receives no cash, to be allocated no taxable gain.

Added Benefits

In this example, the developer received no cash and did not take out any of its equity in the existing venture. As an added twist, proceeds of the financing placed by the new venture could be distributed to the developer. If the new financing is structured properly, this distribution would be tax free.

Thus, the developer could retain long-term ownership, leasing and management, but at the same time receive on a tax-free basis a substantial portion of the cash that would have been payable to the developer in an outright sale.

The developer looking to recapitalize and retain long-term ownership, leasing and management is no longer on the horns of a dilemma. The regulations now provide a clear road map to a recapitalization structure that enables the developer to achieve these goals.

Michael D. Goodwin is a partner in the commercial real estate group at Arnold & Porter in Washington, D.C., which focuses on real estate development and finance.