real estate partnership training. agenda classifying business activity - sb classifying depreciable...
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Real Estate Partnership Training
Agenda
• Classifying Business Activity - SB• Classifying Depreciable Property - SB• Common Book/Tax Differences - MGH• UNICAP/Interest Capitalization – MGH• Liabilities – classification and allocation – MGH• Income/Loss Allocations – MD• Purchase/Sale of Property - MD• Texas Franchise Tax – special considerations - MGH
Activity Classifications
• Page 1 – Ordinary Income/Expenses• Schedule K – Investment Expenses• Form 8825- Rental Real Estate Income and Deductions
Depreciable Property
• Component Cost Allocations (Cost Seg Study)• “Qualified” Property• Bonus Depreciation• Section 179• 27.5 yrs vs 39 yrs • ADS required?
Component Cost Allocations
• Tangible personal property vs. structural components
“Qualified” Property
• As of January 1, 2012 the following “Qualified” Properties are no longer applicable:• Qualified Leasehold Improvements (Section 168(e)(6))• Qualified Restaurant Property (Section 168(e)(7))• Qualified Retail Improvement Property (Section 168(e)(8))
• No longer considered 15 year property; therefore, it is not eligible for Section 179 or Bonus depreciation
Bonus Depreciation & Section 179• Bonus• 2012 & 2013: 50% for new assets with a life of less than 20 years
• Section 179• 2012 & 2013: $500,000 with a $2,000,000 total qualified
investment limitation • Dollar for dollar reduction of deduction above investment
limitation
Common Book/Tax Differences• Rental Income received vs accrued• Tax Rule: advanced rent is taxable upon receipt, regardless of accounting
method• Lease Acquisition Costs• Tax Rule: amounts paid to acquire or renew a lease must be capitalized
and amortized over lease term• Demolition Costs• Tax Rule: must be added to basis of land (not deductible)
• Lessor’s Abandonment of Improvements• Tax Rule: can be written off when lease is terminated
• Election to Capitalize Carrying Charges• Tax Rule: for vacant land, can elect to capitalize taxes, interest, other
instead of take a 2% itemized dedn which may be limited.• Property taxes (discussed later…)• Interest Expense (discussed later…)
Property Taxes• Recurring Item Exception• The election is made simply by using the recurring item exception
for real property taxes or other qualified expense for the first tax year such item is incurred. Although not required, attaching an election statement to the return is recommended.
• Most common treatment for operating entities• Election to Capitalize• For vacant land, to increase the basis of land
• Property under Development• Must capitalize property taxes, even if no development has taken
place, if there is intent to develop
UNICAP Rules• Applies to real or tangible property produced by the taxpayer
and real or tangible property acquired for resale by the taxpayer.• The word “produce” includes construct, build, install,
manufacture, develop or improve.• All direct costs plus a proper share of indirect costs must be
capitalized.• Direct Costs = materials that are part of property and labor
associated with the property• Indirect Costs = indirect labor costs; indirect material; storage
costs; rent; taxes; insurance; utilities; repairs & mtce; Interest• Costs not subject to capitalization = R&D expense; selling costs;
Sec 179 exp; income taxes; warranty costs
Interest Capitalization• Applies to properties that are under development =
DESIGNATED PROPERTY• Does not apply if production period is 90 days or less, AND
cost of production does not exceed [$1 million, divided by # of days in production period].• Example: $15,000 costs, with 60 day expected completion• Capitalization does not apply because $15,000 is less than
$16,666 [$1 million/60 days]• Interest capitalization ceases if production activity stops for at
least 120 days
Interest Capitalization• The amount of interest required to be capitalized must be
determined using the AVOIDED COST METHOD• Theoretically, they would have avoided interest charge if they had
used funds spent on production costs to, instead, pay down debt.• Interest on any debt directly attributable to production
expenditures for designated property (TRACED DEBT) is capitalized first.
• If production expenditures for designated property > traced debt, interest on other debt must be capitalized (EXCESS EXPENDITURE AMOUNT).
• Traced Debt and excess expenditure amounts must be determined for each tax year or shorter production period for each unit of designated property.• Computation period must be at least quarterly.
Interest Capitalization• If debt is incurred by a pass-through entity and the amount of
the entity’s debt is less than its construction costs, then interest of the partner or S corp shareholder may have to be capitalized.
• Pass through the Excess Production Expenditure information on the K-1s.
• Example: Denargo Market, LP
Example• Corporation's outstanding debt at year-end is $350,000. John
and Jim each own 50% of the corporation's stock. Assume again the corporation incurred $400,000 of expenses in the construction of a warehouse, of which $200,000 of debt can be traced directly to construction costs. The remaining $150,000 of debt is also allocated to the building construction because it constitutes avoided-cost debt. Therefore, interest on the entire $350,000 outstanding year-end debt must be capitalized.
• The remaining $50,000 of construction expenditures is allocated to John and Jim based on stock ownership; $25,000 is allocated to each shareholder.
• Therefore, John and Jim must capitalize interest on up to $25,000 of eligible debt, if either has eligible debt
Liabilities• Start with the trial balance, and categorize each liability• If LLC, liabilities are only recourse if the partner loans money
to the LLC. Guarantee of debt does not give at-risk basis (recourse).
• LPs – typically, the normal business liabilities of the partnership (A/P, accruals) are treated as recourse debt to the GP – the GP is the one that creditors can come after if the partnership defaults.
• For cash basis partnerships, accounts payable do not qualify as liabilities (since no current partnership deduction, so no need to increase the partners’ outside basis to allow the deduction).
Recourse Debt
• Partner bears economic risk of loss, or any person related to the partner (i.e. DRE)• Partner loans money to partnership – dollar for dollar allocation• Partner guarantees loan to partnership (does not apply to LLCs) –
dollar for dollar if can be specifically identified, or a prorate share of the related debt
• Examples:• WC 1217-1221 Haven Lane, LP
Nonrecourse Debt
• Liability where no partner bears the economic risk of loss; only creditor bears risk of loss• Most common is a loan for which property (typically real estate)
is pledged as security for repayment and for which the lender’s only remedy in the event of a default is to foreclose on the property.
• Generally allocated among partners in proportion to partners’ profits interests.
• Adds to partner’s basis in partnership, but does not generate at-risk basis for deducting losses.
Qualified Nonrecourse Debt• Gives the partner at-risk basis• Debt that is
• borrowed in connection with activity of holding real property; • secured by the real property itself or other property incidental to the holding of the
real property• loan must be made by entity activity engaged in business of lending money (e.g. a
bank) or must be made or guaranteed by a government entity.• Loan must not be made by the seller of the property securing the debt or a related
person (i.e. seller financing)• Loan must not be made by a broker or other person who received a fee with respect
to the investment in the at-risk activity• Loan cannot be from a related person, except where the loan is commercially
reasonable and on substantially the same terms as a loan involving unrelated parties;
• No person can be personally liable for repayment of the loan;• The loan cannot be convertible debt.
• Allocated based on 752 regulations. Typically, this is based on ownership %. Special allocations can throw this off.
• WC Turtle Creek Partners, LP
Partnership Income Allocations
General Rule –
o Allocation of income and loss is generally made according to the terms of the partnership agreement i.e. agreement Controls § 704(a)
o The partnership agreement may provide different allocation ratios for sharing items of income, gain, deduction, losses among the individual partners. When an allocation ratio differs from the partner's profit and loss sharing ratio, or it differs from a partner's relative capital contribution, it is referred to as a special allocation.
Exceptions to the General rule: The Agreement will not be applicable if -o There is no Agreement o Agreement Lacks Substantial Economic Effect (SEE)o Pre contribution Gains and Losses involved §704(c)o Other exceptions..
Under §704(b), a tax allocation to a partner is valid if it:
1. Is in accordance with the “partner’s interest in the partnership” (PIP) - the general rule OR
2. Has Substantial Economic effect (SEE) ( the safe harbor rules)
The purpose of both tests is to ensure each tax allocation matches the partners’ corresponding economic allocations.
For the most part, the rules for determining a partner’s interest in the partnership and for determining whether a tax allocation has substantial economic effect are similar.
Allocations will be respected under either set of rules.
Note that some items do not have any corresponding economic element and hence the SEE test does not apply to the allocation of such items. Examples include tax credits, non recourse deductions attributable to the nonrecourse liabilities etc.. Safe harbor allocations of these tax items must be made under special rules explained later.
The PIP Test
o A partner’s interest is a facts-and-circumstances determination which considers: -
Relative contributions to the partnership Interest in economic profits and losses Interest in cash flow and non-liquidating distributions as well as in
liquidating distributions.
o The analysis of a partner’s interest in the partnership is probably best done using a capital account approach similar to that used under the SEE safe harbor rules.
Substantial Economic Effect (SEE Test) - SEE Test (Two Fold) - Under the substantial economic effect rules –
1. The allocations must have “ECONOMIC EFFECT”. Economic effect principles contemplate matching i.e. if a partner reaps the economic benefit of an income or loss allocation, that same partner is allocated the corresponding income or loss for tax purposes.
2. The allocations must be “SUBSTANTIAL”.
Economic Effect: Economic effect is met if all three of the following requirements are met:
1. Capital account maintenance: Partners' capital accounts are maintained in accordance with the rules found in the 704(b) Regulations.
2. Liquidation proceeds: Proceeds in liquidation must be distributed according to the positive capital accounts balances of the partners.
3. One of the Following: -A. Obligation to restore: Any partner with a deficit capital account
balance following the liquidation of an interest in the partnership is unconditionally obligated to restore that deficit.
B. Qualified Income Offset - Since Limited partners or LLC members will not like requirement 3A (deficit restoration obligation) they will opt for this “alternate” test. In the event, an unexpected event (such as distribution) creates a deficit balance (allocations of deduction and loss cannot create a deficit) there shall be an immediate allocation of of income to eliminate deficit – QIO provision.
Substantiality Test. - An Allocation is substantial if there is reasonable possibility that the allocation will substantially affect the dollar amounts to be received, independent of tax considerations.
Unlike the more objective tests for economic effect, the rules for substantiality are more subjective.
So how do you know if you allocations have economic effect?
o Contributions +/- Allocations = Distributions
o Most Agreements are designed to satisfy this formula over the lifetime of the partnership.
o If no matter when the partnership liquidates the formula holds true, then the partnership has gone a long way towards complying with the tax rules.
Example – o A partnership agreement may require that partners F and G share equally
in profits and losses, except that partner F would be specially allocated 100 percent of the depreciation on a building. If the building is later sold for a profit of $50,000, and the gain is shared equally by F and G, then either the allocation or the profit on the building would not be consistent with the underlying economic arrangement of the partners. Thus, the IRS could re-determine the partner's distributive share of income according to what the Service determines to be the partners' true interest in the partnership.
Defining a partner's capital account: - The one constant in the above two tests is capital accounts.
o Capital Accounts under discussion are economic capital accounts and not tax basis capital accounts. Capital accounts are a partnership accounting mechanism and not a tax mechanism.
o Capital accounts, as opposed to basis, can be negative, o Capital accounts help determine amounts that a partner is entitled to
receive upon a sale or liquidationo A partner's share of liabilities is not reflected in the capital account. Upon
initial contribution, assets net of any liabilities will be reflected in the capital accounts.
o The partnership must also maintain the partners' capital accounts on a book basis rather than on a tax basis. This means that contributions of property and distributions must be reflected in capital at fair market value, rather than adjusted tax basis
ALLOCATIONS OF NONRECOURSE DEDUCTIONS – for e.g. depreciationo Nonrecourse deductions are those financed by nonrecourse debt.o By definition, the economic detriment associated with such deductions is
borne by the nonrecourse creditor, not a partner. An allocation of nonrecourse deductions cannot, therefore, have economic effect and must be allocated in accordance with the partners’ interests (PIP).
SPECIAL ALLOCATIONS OF NONRECOURSE DEDUCTIONS - o One “deems” the allocations to be in accordance with the partners’
interests if the following requirements are met - The three requirements noted earlier for the SEE test The non-recourse allocations are reasonably consistent with a
recourse allocation that has SEE or under the PIP standard. This means that the allocation of non-recourse deductions must be made in a manner similar to the allocation of items which do have substantial economic effect. Thus, a partnership would not be able to allocate all depreciation deductions to one partner while allocating all other items on a 50/50 basis.
The partnership agreement contains a “minimum gain chargeback” provision.
Minimum Gain Chargebacko The general idea behind the minimum gain chargeback is that a partner
who receives the tax advantage of a deduction for which he or she bears no economic risk of loss (such as depreciation deductions) may bear a tax liability in the future due to an allocation of income. This allocation of income is called a “minimum gain chargeback.”
o At the appropriate time, income must be allocated to the partner who received the corresponding non-recourse deductions. This occurs when there is a decrease in minimum gain.
o A net decrease in partnership minimum gain occurs when: Debt is repaid Taxable disposition of the property secured by the debt A non-recourse liability is converted to a recourse liability.
In short a §704(b) Compliant Agreement Contains o Capital accounts per §1.704-1(b)(2)(iv) o Liquidating distributions follow ending capital o One of the following
• Deficit restoration obligation • Qualified income offset
o Minimum gain chargeback
Partnership income is taxed on a flow-through basis to the partners whether or not cash is currently distributed. This requires partnerships utilizing regulatory allocations to determine two things to keep matters straight: o How income and loss is allocated among the partners (the “allocation
waterfall”); ando How cash is distributed among the partners (the “distribution
waterfall”).
A typical real estate partnership agreement drafted using a waterfall (layer cake) approach contains several tiers of income/loss allocations that define the priority in which partnership items of income/loss are to be allocated. These agreements also contain several tiers of cash distribution provisions that define how partnership cash gets distributed to the partners.
o The agreement typically contains key provisions that extract language from the regulations to allow the allocations to meet the SEE test, thus allowing the allocations to be respected under Sec. 704(b).
Following is an example of computing income allocations under the waterfall approach.
o Partner A of AB Partnership contributes $100,000 cash to AB, and partner B contributes $50,000 cash. The partnership agreement dictates that profits are allocated to each partner first to the extent of a 5% cumulative annual preferred return on unreturned capital and second 50% to A and 50% to B. Losses are allocated first to the extent of positive capital account balances and second 50% to A and 50% to B. Cash is first disbursed to pay the preferred return, second to pay any unreturned capital, and last 50% to A and 50% to B.
o In year 1, AB had net income from ordinary operations of $60,000 and distributed the entire $60,000 in cash. Under this traditional waterfall allocation, the income allocation will be as follows
o Profit allocations in year 1 to A would be $31,250 and to B would be $28,750, for a total income allocation of $60,000.
Year 1 capital accounts
A B TOTAL
Initial Cap Contribution
100,000 50,000 150,000
Tier 1 Profit (Preferred return)
5,000 2,500 7,500
Tier 2 Profit (50/50) 26,250 26,250 52,500
Tier 1 Cash (Preferred return)
(5,000) (2,500) (7,500)
Tier 2 Cash (ROC) (35,000) (17,500) (52,500)
End of Year Capital 91,250 58,750 150,000
In year 2, the partnership has $10,000 of income and distributes $110,000. Profit allocations in year 2 to partner A would be $5,813 and to partner B would be $4,187, for a total income allocation of $10,000.
A B TOTAL
Beginning Capital 91,250 58,750 150,000
Tier 1 Profit (Preferred return)
3,250 1,625 4,875
Tier 2 Profit (50/50) 2,563 2,562 5,125
Tier 1 Cash (Preferred return)
(3,250) (1,625) (4,875)
Tier 2 Cash (ROC) (65,000) (32,500) (97,500)
Tier 3 Cash (50/50) (3,813) (3,812) (7,625)
End of Year Capital 25,000 25,000 50,000
The “Layer cake” approach can result in unusual and confusing language and can be quite complex.
In response to these complex distribution provisions, more and more tax practitioners are abandoning the use of “layer cake” or “waterfall” allocations and are relying on “Target” or “forced” allocation provisions instead.
The Target capital account provision says “Allocate -- so that capital accounts equal the amounts the members would receive in a liquidating distribution”.
Allocations are backed into by forcing the capital account balances to be what the partners would receive in a hypothetical liquidating distribution for each member.
Partnership agreements that use target allocations usually do not liquidate in accordance with positive capital account balances (and hence not presumed to satisfy the SEE test).
Despite the fact that target allocations don't satisfy SEE, these allocations should be “be consistent with the partners' interest in the partnership (“PIP”); and should be a viable drafting alternative to strict compliance with the SEE safe harbor.
Target allocation not used in certain situations – e.g. tax exempt partner in a real estate partnership (fraction rule provisions)
Both method are intended to get to the same place, however if something goes wrong, different methods seek to save different aspects -o Targeted Allocations – Economic terms (distributions are thought to be
safe). o Layered allocations – tax treatment is thought to be safe.
See WC 8201 Burnet – Layer Allocation See WC 4th and Co – Target Allocation
Purchase and Sales Closing Statements
Texas Franchise Tax – Special Considerations• Combined reporting• Passive income includes capital gain from sale of real property• Rental income – gross rents • Annualization rules for first year entities (for using EZ Method)
MLR Resources• PPC Deskbook on Real Estate Taxation in Checkpoint• BNA Real Estate Portfolios in Checkpoint• LexisNexis books on Federal Taxes Affecting Real Estate at
Melissa’s desk• Haynes Boone contact – Brandon Jones