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Two people are 50-50 owners, through a partnership, of an office tower worth $100 million. One of the owners, let's call him McDuck, wants to cash out, which would mean a $50 million gain and $7.5 million in capital-gains taxes.
1. McDuck needs to turn his ownership of the property into a loan. So the partnership borrows $50 million and puts it into a new subsidiary partnership, which contributes the cash to yet another new partnership.
2. The newest partnership lends that $50 million to a finance company for three years in exchange for a three-year note. (The finance company takes the money and invests it or lends it out at a higher rate.)
3. The original partnership distributes its interest in the lower-tier subsidiary to McDuck. Now, McDuck owns a loan note worth $50 million instead of the property, effectively liquidating his 50 percent interest.
4. Three years later the note is repaid. McDuck now owns 100 percent of a partnership sitting on a $50 million pile of cash—the amount McDuck would have received from selling his stake in the real estate—without triggering any capital-gains tax.
5. While this cash remains in the partnership, it can be invested or borrowed against. When McDuck dies, it can be passed along to heirs and liquidated or sold tax-free. The deferred tax liability disappears upon McDuck's death under a provision that eliminates such taxable gains for heirs.
Wealthy Boston real estate developer Arthur M. Winn used a version of this transaction. In 2008 a U.S. Tax Court judge ruled that one aspect of the deal was perfectly legal. Other aspects of the transaction are being settled with the government.
Next: The Estate Tax Eliminator