Tax Issues on Dispositionof a Project

IPEDBoston, October 2007

Forrest David Milder617-345-1055

fmilder@nixonpeabody.com

Computing the Partners’ Shares of the Proceeds

• There’s usually a “waterfall”

• But, on liquidation, that’s just a “target”; it’s not how the proceeds necessarily get distributed

• Liquidation proceeds are distributed in accordance with “capital account” because the Treasury Regulations require distributions to be done that way. If you don’t follow the Treasury Regs, then the Investor won’t be able to get a tax opinion that the allocation of tax credits will be “respected”.

Computing Capital Account

Capital Account is computed in accordance with Regulations. The essential rules:

• Increased by cash in and share of profits

• Decreased by cash out and share of losses

• Tax Credits generally don’t affect the computation

How Things Have Changed

• In the earlier years of the credit, partners didn’t pay much for their investments, so depreciation deductions caused their capital accounts to go to zero, and there weren’t many surprises.

• But: Many things have changed; two in particular –

• Much higher prices per credit means that investors still have positive capital accounts 15 years later

• State credit investors have positive capital accounts

Implications of Large Capital Accounts

• Investors’ share may be higher than was expected

• Even though it “has to work”, somehow it doesn’t. The numbers never match what is available to distribute.

Illustration

Suppose:

• Suppose a $5m project in a DDA.

• With 10% allocated to land, we have a qualified basis of $4.5m times 130% or $5.85m

• Further suppose an 8% credit rate, and 90 cents paid per credit dollar. So, the investor pays $4.2m (that’s $5.85 times 8% times 90%)

• We borrow $800K from a bank for the balance. GP puts in $100.

Summary of Initial Funding

That’s:

• $0.0m capital account for GP

• $4.2m capital account for Investor

• $0.8m loan from bank

• $5.0m total funds

The Waterfall

Suppose that the “waterfall” is 10% to the investor and 90% to the GP. Of course, the regulations require us to “respect” capital accounts, so the waterfall can only “kick in” once the capital accounts have been taken

care of.

Capital Accounts in Year 15

• Suppose the project runs at cash flow break-even, and the loan is interest only.

• Over 15 years, investor gets 15 years of depreciation, or $2.45m. (that’s $4.5 times 15/27.5

• So, the investor’s capital account is $4.2m less the $2.45 of depreciation, or $1.75m. GP gets a trivial depreciation deduction. Suppose it has a capital account in year 15 of $50.

Summary of 15th Year Capital Account

That’s:

• $0.0m capital account for GP

• $1.75m capital account for Investor

• $0.8m loan from bank

• $2.55m to be accounted for

Sale of the Project

• Now suppose the project is sold for $3m.

• Basis is $2.55 (this is what’s left after $5m is reduced by $2.45m of depreciation).

• So, the gain is .45m. (that’s $3m less $2.55m)

• Suppose that we allocate all of the gain to the GP. Now, the partners’ capital accounts are $.45m for the GP and $1.75m for the LP.

Capital Accounts after Gain is Allocated

That’s:

• $0.45m capital account for GP

• $1.75m capital account for Investor

• $0.8m loan from bank

• $3.0m to be accounted for

Distributing the Proceeds

• We have $3m of proceeds. We use:• .8m to pay off the bank loan

• 1.75m for the investor

• .45m for the GP

• 3.00m

• So, when we distribute in accordance with capital accounts, the GP gets $450,000, and the LP gets $1,750,000.

• Compare: without capital accounts,10% to the Investor and 90% to the GP would be $1,980,000 to the GP, and 220,000 to the LP

Tax Consequences

It’s the sale of a partnership interest or the project that gives rise to income or gain. The actual distributions of

cash are generally not taxable, since the partners just get back their capital account.

Taking Subject to Debt

Nonrecourse debt on the property is part of the proceeds of sale in computing taxable gain. E.g.:

• Suppose property is sold for $1.5m of cash plus “taking subject to” a $2.5m nonrecourse loan.

• Suppose that the seller has a $2.1m basis in the property.

• So, the taxable gain is $1.9m – that’s $1.5m of cash plus $2.5m of debt less 2.1m of basis, or $1.9m.

• Note that the gain, $1.9m, is larger than the cash received on the sale, $1.5m.

More Tax Rules

• Most investors are corporations. Everything is taxed at a 35% rate. That includes ordinary income, depreciation recapture, and capital gains

• For individuals, the rates are all over -- 15% for capital gains, but 25% for depreciation “recapture”, and 35% for ordinary income (there probably won’t be much, if any; e.g., rent receivables).

• If an individual has passive loss carryovers, it may be able to use the “backed up” deductions against its 35% income and pay lower tax rates on the income.

• Of course, there’s also potential recapture of the credits if the project is sold, or more than one-third of the investor’s interest is sold, before the end of the 15-year compliance period.

Using Like-kind Exchanges with Older Housing Projects

By Forrest David Milder

Nixon Peabody LLP

617-345-1055

Sponsor Entity (General Partner)

InvestorLimited

Partnership(Limited Partner)

Operating Partnership

HousingProject

Like-Kind Exchange Model

QualifiedIntermediary

Sponsor Entity 2

Credit TenantProperty Owner

Credit TenantProperty

Sponsor Entity 1(General Partner)

InvestorLimited

Partnership(Limited Partner)

Operating Partnership

Credit TenantProperty

Like-Kind Exchange Model (cont.)

HousingProject

Sponsor Entity 2

Optimal Projects

• Large Negative Capital Accounts

• Low Basis

• Properties With Low Net Value

• Economic Opportunity to Unlock

Optimal ProjectsEconomic Opportunity to Unlock

• Section 42 Resyndication

• last placed in service at least 10 years ago

• rehabilitation of at least $3,000 per unit or 10% of basis

• credit allocation or volume cap bonds

• Refinancing/restructuring of debt