year 15 dispositions & capital accounts panelists: bill letsinger, cpa partner novogradac &...

Year 15 Dispositions & Capital Accounts

Panelists:

Bill Letsinger, CPAPartner

Novogradac & Company LLP

Craig Staswick, CPAPrincipal

Novogradac & Company LLP

Copyright (c) 2014 Novogradac & Company LLP

Kinds of Year 15 Dispositions

• Sale of partnership interest• Sale of all partnership interests to one person (Rev. Rul.

99-6 treats this as sale of property by partners)• Sale of property by partnership• Donation of partnership interest, including “part gift-

part sale”


Early Buyout of LP

Why does GP want LP to exit early?

Property has value, or will!

Option to buyout LP for debt and exit taxes might be less before

Y15

Why wouldn’t GP want LP to exit early?

LP might demand lots of money

Option to buyout LP in Y15 might be cheaper if LP capital projected

to be close to zero

Some LPs demand that the GP post a bond


Early Buyout of LP

Why would LP want to leave early?

Property has no value; no point in sticking around

Relieve yourself of asset management duties and other reporting requirements

Accelerate some tax losses into year of exit and/or potentially avoid exit taxes

Why wouldn’t LP want to exit early?

Property has lots of value! Early exit might forfeit that value

Don’t trust GP to keep property compliant

Exposure from extending the statute of limitations


Right of First Refusal

• Under IRC § 42(i)(7) nonprofits often can purchase the property for:– Partnership debt; plus– Exit taxes which includes:• Phantom income from negative capital account• State and local taxes attributable to sale

• If taxes don’t exist, then just assume debt


Qualified Contracts

• Qualified contracts can be exceptionally complex

• IRC § 42(h)(6)(F) and Treas. Reg. § 1.42-18 don’t answer all of the questions of qualified contracts

• California regulatory agreement does not provided for qualified contract option


Year 15 Disposition Consequences

Two aspects of dispositions to remember:

Cash

Allocation of cash distribution dependent on capital accounts which is

affected by gain/loss allocation

Exit Taxes

Different tax rates can apply to different kinds of income or gain.


Tax Issues to Remember

• Capital Gain vs. Depreciation Recapture vs. Ordinary Income

• Distributions in Accordance with IRC § 704(b) Capital Accounts

• Nonpayment of Deferred Fees

• Installment Sales

• Partnership Termination


Example of Tax Rates on Property Sale

• Suppose the property originally cost $4M. Fifteen years later it has been depreciated to $2.2M. The sales price is $5M.

• So, we have $2.8M of gain (that is, $5M less $2.2M)

• For a corporate partner, the tax rate is 35%, or $980K

• For an individual partner, the tax rate is 25% times the depreciation recapture and 20% times the capital gain –

– Original price less current basis is depreciation recapture. That’s $4M - $2.2M, or $1.8M. At 25%, that’s $450K of tax, plus

– Sales price less original price, which is capital gain. That’s $5M less $4M, or $1M. At 20%, that’s $200K.

– Total tax bill is $450k + $200K, or $650K.


Capital Gain v. Depreciation Recapture v. Ordinary Income

• Corporations generally pay the same 35% federal rate on all three

• Individuals pay different federal rates as follows:

– Capital gain – 20%

– Straight-line depreciation recapture – 25%

– Accelerated depreciation recapture – 39.6%

• Receivables treated as “hot assets” under IRC § 751 - 39.6%

• Applies even if the partnership interest (rather than partnership assets) is sold.


IRC § 704(b) Capital Accounts

Capital accounts adjustments include:• Partner’s investment (increase)• Share of profits (increase)• Contributions (increase)

• Losses (decrease)• Syndication costs (decrease)• Distributions (decrease)


IRC § 704(b) Capital Accounts Continued

• IRS requires that on liquidation, distributions must be made in accordance with capital accounts.

• Treasury Regulation 1.704-1(b)(2)(ii)(b)(2) indicates that cash is distributed according to positive capital accounts.


When is a waterfall not a waterfall?• Partnership Agreement says: Waterfalls govern cash splits of a sale

BUT• IRS says that liquidation allocations be made in accordance with the

positive capital account balances of the partners.• §9.2.B (Proceeds from Sale or Refinance) is subject to §12.4

(Liquidation)• §12.4 says on liquidation:• after payment of Liabilities BUT before the final splits,• balance of PA assets of the Partnership shall be distributed according

Partners’ capital account balances.• determined AFTER all allocations for the year during which the

liquidation occurred have been made. • Must calculate LP capital account after sale of property (and allocation

of all “book profits” from sale)


Capital Accounts… IRC §704(b) issue

• LP cannot claim losses & credits • Investor in turn cannot claim losses & creditsRisk

• Deferred developer fee (DDF) disaffiliation• Allocate losses to the extent of operating deficit to GP• Create income • Write off liabilities (DDF expected to be paid?)• Deficit restoration obligations (Last resort)

Strategies to Reduce Risk

704(

b) I

ssue

!!!


Maintenance of Capital Accounts and Substantial Economic Effect

“The foregoing provisions and the other provisions of this Agreement relating to the maintenance of Capital Accounts are intended to comply with Treas. Reg. § 1. 704-1(b), and shall be interpreted and applied in a manner consistent with such regulations. It is the intention of the Partners that the Capital Accounts maintained under this Agreement be determined and maintained throughout the full term of this Agreement in accordance with the accounting rules of Treas. Reg. §1.704-1(b)(2)(iv).”


Reasons LP’s Capital Account may be Positive

• Little or no excess basis in property

• Project is in DDA or QCT

• Financing is mostly equity

• Property has little or no losses

• Don’t have loans that accrue unpaid interest


Reasons LP’s Capital Account may be Negative

• Excess basis in property

• Tax-exempt bond project

• Low credit price

• Many financing sources

• Property has big losses often including accrued but unpaid interest

• Bonus depreciation


The Good

GP LP

Capital Account Prior to Sale $ (25,000) $ (575,000)

Capital Accounts Pre Sale


The Good

Sales Price $ 8,450,000 Fixed Assets $ 7,600,000 Less Acc. Depreciation (4,750,000) $ 2,850,000 Land 100,000 Basis 2,950,000 Gain (Loss) on Sale $ 5,500,000

The Sale


The Good

Sales Price $ 8,450,000

Mortgage - 3,450,000

Transaction Costs - 100,000

3,550,000

Cash to Distribute $ 4,900,000

Cash to Distribute

The Good

GP LP Total

Capital Account Prior to Sale $ (25,000) $ (575,000) $ (600,000)Gain on Sale: $5,500,000 Gain Alloc. to Offset Negative Capital 25,000 575,000 600,000 Capital Account After Initial Alloc. - - -

Gain Alloc. to Follow Partner Split 4,719,615 180,385 4,900,000 Gain Reallocation For LP Exit Taxes* (Assume 35%) (309,615) 309,615 -

Capital Account Before Liquidating Distribution 4,410,000 490,000 4,900,000 Cash Distributed 4,410,000 490,000 4,900,000

Cash Split 90% 10% 100%

*Exit tax based on negative LP capital (also includes tax on distributions for exit tax)

(Because 90/10 Cash Split Satisfied)



Total Gain Including

Exit TaxTax

Rate Exit Tax 575,000 35% 201,250 776,250 35% 70,438 846,688 35% 24,653 871,341 35% 8,629 879,969 35% 3,020 882,989 35% 1,057 884,046 35% 370 884,416 35% 129

Additional iterations are not shown

Exit Tax 309,615

Calculations to Determine LP’s Exit Tax


Gain Divided by (One Less Tax Rate)

575,000 / (1 - .35) = 884,615 Less Phantom Income (575,000)Exit Tax 309,615

Alternative LP Exit Tax Calculation


LP’s Schedule K-1

(575,000)

-

1,065,000

490,000 -

X


The Not-So-Good

GP LP

Capital Account Prior to Sale $ (25,000) $ 2,300,000



The Not-So-Good

Sales Price $11,300,000 Fixed Assets $11,500,000 Less Acc. Depreciation (3,825,000) $ 7,675,000

Land 1,700,000 Basis 9,375,000

Gain (Loss) on Sale $ 1,925,000


The Not-So-Good


First Mortgage $ 6,750,000 Second Mortgage 250,000 7,000,000

Transaction Costs 100,000 7,100,000

Cash to Distribute $ 4,200,000


The Not-So-Good

GP LP TotalCapital Account Prior to Sale $ (25,000) $ 2,300,000 $ 2,275,000

Gain on Sale: $ 1,925,000 Gain Alloc. to Offset Negative Capital 25,000 - 25,000 Capital Account After Initial Alloc. - 2,300,000 2,300,000

Gain Alloc. to Follow Partners Split 1,900,000 - 1,900,000 Gain Reallocation For LP Exit Taxes (Assume 35%) - - -

Capital Account Before Liquidating Distribution 1,900,000 2,300,000 4,200,000

Cash Distributed 1,900,000 2,300,000 4,200,000 Cash Split 45% 55% 100%

Because 90/10 Cash Split Not Fully Satisfied


LP’s Schedule K-1

2,300,000 -

-

X

-

2,300,000


The Ugly

GP LP

Capital Account Prior to Sale $ (450,000) $ (1,500,000)



The Ugly


Fixed Assets $14,000,000 Less Acc. Depreciation (7,800,000) $ 6,200,000

Land 600,000 Basis 6,800,000 Gain (Loss) on Sale $ 2,000,000


The Ugly


First Mortgage $ 7,635,000 Second Mortgage(s) 1,015,000 8,650,000

Transaction Costs 100,000 8,750,000

Cash to Distribute $ 50,000

The UglyGP LP Total

Capital Account Prior to Sale $ (450,000) $ (1,500,000) $ (1,950,000)

Gain on Sale: $ 2,000,000 Gain Alloc. to Offset Negative Capital 450,000 1,500,000 1,950,000 Gain Alloc. to Follow Partner Split 50,000 - 50,000Gain Reallocation For LP Exit Taxes* (Assume 35%)

(807,692) 807,692

-

Capital Account Before Liquidating Distribution (757,692) 807,692 50,000Cash (Contributed) Distributed (757,692) 807,692 50,000Cash Split -1,515% 1,615% 100%

*Exit tax based on negative LP capital (also includes tax on distributions for exit tax)

(Because GP Contributes Cash)



Total Gain Including

Exit Tax Tax Rate Exit Tax

1,500,000 35% 525,000 2,025,000 35% 183,750 2,208,750 35% 64,313 2,273,063 35% 22,509 2,295,572 35% 7,878 2,303,450 35% 2,757 2,306,208 35% 965 2,307,173 35% 338

Additional iterations are not shown

Exit Tax 807,692

Calculations to Determine LP’s Exit Tax


Gain Divided by (One Less Tax Rate)

1,500,000 / (1 - .35) = 2,307,692

Less Phantom Income (1,500,000)

Exit Tax 807,692

Alternative LP Exit Tax Calculation


LP’s Schedule K-1

(1,500,000)

-

-

X

807,692

2,307,692

Copyright © 2014 Novogradac & Company LLP

Nonpayment of Deferred Fees• Suppose that it’s year 15, and the development fee is

unpaid.• The IRS may dispute if the development fee is eligible basis.• GP will often have to pay development fee as capital

contribution by year 13 (IRS TAM 200044004).– Developer (often also the GP) receives the cash back as payment

– Developer recognizes income• No change in net cash for Developer (if also the GP)

– Losses could be allocated to GP to offset income

year 15 dispositions & capital accounts panelists: bill letsinger, cpa partner novogradac &...

Documents

lp capital

property sale

sale copyright c

early exit

buyout lp

early buyout of lp

debt copyright c

exit taxes