Getting Into and Out of a Real Estate Partnership

1. Getting Into and Out of aReal Estate Partnership Howard E. Abrams Professor, Emory Law School www.taxnerds.com

2. Carried Interests: Case 1 R contributes cash of $100,000 and S contributes services. S receives a carried interest of 10%. The partnership purchases two assets for $50,000 each. The first asset eventually is sold for $80,000 and the second asset eventually is sold for its cost of $50,000. All profits are allocated 90% to R and 10% to S. No cash is distributed until the partnership liquidates.

3. Carried Interests: Case 2 R contributes cash of $100,000 and S contributes services. S receives a carried interest of 10%. The partnership purchases two assets for $50,000 each. The first asset eventually is sold for $80,000 and the second asset eventually is sold for its cost of $50,000. All profits are allocated 90% to R and 10% to S. Cash is distributed as received, with the first $100,000 distributed to R.

4. Carried Interests: Case 2A R contributes cash of $100,000 and S contributes services. S receives a carried interest of 10%. The partnership purchases two assets for $50,000 each. The first asset eventually is sold for $80,000 and the second asset eventually is sold for its cost of $50,000. All profits are allocated 90% to R and 10% to S. Cash is distributed as received, first as gain was allocated, then as capital was contributed.

5. Carried Interests: Case 3 R contributes cash of $100,000 and S contributes services. S receives a carried interest of 10%. The partnership purchases two assets for $50,000 each. The first asset eventually is sold for $80,000 and. All profits are allocated 90% to R the second asset eventually is sold for only $30,000 and 10% to S. Cash is distributed as received, first as gain was allocated, then as capital was contributed. Losses back-out gains.

6. Carried Interests: Case 3A R contributes cash of $100,000 and S contributes services. S receives a carried interest of 10%. The partnership purchases two assets for $50,000 each. The first asset eventually is sold for $80,000 and. All profits are allocated 90% to R the second asset eventually is sold for only $30,000 and 10% to S. Cash is distributed as received, first as gain was allocated, then as capital was contributed. S is not subject to a claw-back.

7. Carried Interests: Conclusion 1 • If allocations are not made on the carried interest until all capital is returned to the investor partners, the service partner will receive less than the full carried interest if there is insufficient gain to the partnership after capital has been returned.

8. Carried Interests: Conclusion 2 • If allocations are made on the carried interest from the start but distributions are made only to the investor partners until all capital is recovered, then the service partner has phantom income in the early years.

9. Carried Interests: Conclusion 3 • If allocations are made on the carried interest from the start and distributions are made on the carried interest before all capital is returned, then late taxable losses must be disproportionately allocated to the investor partners (changing the economics of the deal) or the service partner must be subject to a claw-back obligation.

10. Contribution of Appreciated Property • Under section 704(c), pre-contribution appreciation must be allocated to the contributing partner. For book purposes, this means that contributed property is booked in at current fair market value. The variation between book value and carry-over tax basis is addressed by one of the three 704(c) recovery methods.

11. Contribution of Depreciable Property • If the contributed property is depreciable, the partnership steps into the contributing partner’s shoes for tax purposes pursuant to section 168(i)(7). • For book purposes, a proportionate rule is used for the traditional and curative 704(c) methods. But for the remedial allocation method, the property is bifurcated.

12. Depreciable Property Example • Example: Property has value of $10,000 and adjusted basis of $6,000. The property has 5 years remaining to its depreciable life; if the property were newly placed in service, it would have a depreciable life of 8 years. The property is depreciated using the straight-line method. • Tax depreciation is $1,200 per year for 5 years pursuant to section 168(i)(7).

13. Traditional and Curative Methods • For the traditional and curative methods, book depreciation is to book value as tax depreciation is to adjusted basis. Accordingly, since tax depreciation is 20% of adjusted basis each year for 5 years, book depreciation is 20% of book value (i.e., $2,000) each year for 5 years.

14. Remedial Allocation Method • For the remedial allocation method, we bifurcate the property into an unappreciated (old) component recovered over the remaining recovery life and a fully appreciated (new) component recovered over a new recovery life. • The old piece has book value equal to tax basis of $6,000, recovered over 5 years.

15. Remedial Allocation Method • The new piece has book value of $4,000 but $0 tax basis, and the book value is recovered as if newly placed in service (that is, over 8 years). • In years 1-5, book depreciation equals $1,200 + $500 per year, or $1,700. Tax depreciation equals $1,200 per year. • In each year 6-8, book depreciation is $500 and tax depreciation is $0.

16. Example 1: Nondepreciable Property P contributes cash of $10,000 and Q contributes nondeprecable property with value of $10,000 and adjusted basis of $6,000. The property eventually is sold for $12,000. On the sale, there is book gain of $2,000 and tax gain of $6,000; that is, there is $4,000 of tax gain in excess of book gain.

17. Example 2: Depreciable Property Assuming the partners agree to share book allocations 50-50, each partner is allocated $1,000 of book depreciation. The noncontributing partner is allocated tax depreciation equal to book depreciation, and the contributing partner is allocated the remainder of the tax depreciation. Here, that is $200 of tax depreciation. This example assumes the remedial allocation method is not used.

18. Example 2: Continued If this continues for the next 4 years (that is, through the remaining recovery period of the property), then the book/tax disparity for Q is fully eliminated. Note that capital accounts were always correct; over time, Q’s tax account becomes aligned with Q’s book account.

19. Example 3: Ceiling Limitation P contributes cash of $10,000 and Q contributes nondeprecable property with value of $10,000 and adjusted basis of $6,000. The property eventually is sold for $7,000. On the sale, there is book loss of $3,000 and tax gain of $1,000. This yields a permanent book/tax disparity for each partner in equal but opposite amounts.

20. Example 3: Curative Allocation If the partner has unrelated income (or loss) of the same character, it can skew the tax allocation of that income (or loss) to offset the book/tax disparities. In this example, $3,000 of income has been used to cure the ceiling limitation.

21. Example 4: Depreciable Property Assuming the partners agree to share book allocations 50-50, each partner is allocated $1,000 of book depreciation. The noncontributing partner cannot be allocated tax depreciation equal to book depreciation because there is only $800 of tax depreciation. Accordingly, there is a book/tax disparity of $200 for each partner.

22. Example 5: Remedial Allocation If the remedial allocation method is adopted, the book depreciation is reduced to $1,400 in the first year. Accordingly, the ceiling limitation problem disappears! (We are assuming that the property, if newly placed in service, would be depreciated over 10 years.)

23. Example 5: Years 2-5 The analysis does not change in years 2-5, as shown above. However, in year 6 there will be book depreciation but no tax depreciation.

24. Example 5: Year 6 In year 6 there is book depreciation of $600 (all from the “new” piece) but no tax depreciation. Accordingly, a remedial allocation will be triggered.

25. Partial Disposition • X and Y each own half of the XY partnership with outside basis of $200. XY owns Blackacre with basis of $400, value of $500, and subject to a debt of $380. Y sells one-half of her interest to Z for its value of $30, with half of Y’s debt shifting to Z. • Y’s gain equals amount realized of $125 [$30 + $90] less allocable basis of $100, or $25.

26. Partial Disposition: Rev. Rul. 84-53 • What if none of the debt shifts from Y to Z? If we reduce amount realized from $125 to $30, then Y recognizes a loss on the transaction even though Blackacre has appreciated. • Under Rev. Rul. 84-53, debt is removed from outside basis on a partial disposition except to the extent it shifts as a result of the transaction. Accordingly, gain is $30-$5, or $25.

27. Dispositions After Distributions • Facts: X owns 60% and Y owns 40% of the XY-LLC. XY owns a single, nondepreciable asset with adjusted basis and book value of $0 and value of $2,000. Each partner has a $0 outside basis and capital account, and no partner has a deficit restoration obligation.

28. Full Sale with Debt Shift XY borrows $500 against its asset and distributes the proceeds to X and Y. Y then sells her partnership interest to Z, and Y’s share of the liability shifts to Z. Y’s gain equals $800. Z has an outside basis of $600 + $200 and Y’s capital account of $600. Z enjoys an inside basis adjustment of positive $800. Thus, if the asset is sold, X is taxed on $1200 and Z on nothing.

29. Full Sale Without Debt Shift XY borrows $500 against its asset and distributes the proceeds to X and Y. Y then sells her partnership interest to Z, and Y’s share of the liability shifts to X. Y’s gain equals $800. Z has an outside basis of $600 and Y’s capital account of $600. Z still enjoys an inside basis adjustment of positive $800. Thus, if the asset is sold, X is taxed on $1200 and Z on nothing.

30. Partial Sale Without Debt Shift Y sells have of her interest for its value of $300. No debt shifts from the sale. Y’s gain on the sale equals $300. Immediately before the sale, Y’s built-in gain equaled $800. How much of that gain moves to Z? Note that Y recognized a gain of $300 on the sale to Z. Note also that Z’s inside basis adjustment under section 743(b) will equal Z’s share of the built-in gain in all events.

31. Shifting Half the Built-In Gain? If half of Y’s built-in gain is shifted to Z, then when the property is sold, the $2,000 of tax gain will be allocated $1,200 to X, $400 to Y, and $400 to Z, with Z’s share offset by the 743(b) adjustment. Since Y reported only a $300 gain on the sale to Z, this means $100 of appreciation in the asset has gone untaxed (note the book/tax disparity for Y). Only $300 of the built-in gain should have shifted on the partial sale from Y to Z, leaving $500 of gain for Y on asset sale.

32. Shifting Only the Right Gain If only $300 of Y’s built-in gain is shifted to Z, then when the property is sold, the $2,000 of tax gain will be allocated $1,200 to X, $500 to Y, and $300 to Z, with Z’s share offset by the 743(b) adjustment. Now, Y does not escape any gain. Note that Z’s capital account, outside basis, and net income recognition are unaffected.

33. Sell, Distribute or Both • Facts: X and Y each contribute $100 to the XY partnership. XY purchases a nondepreciable asset for $200, and when it increases in value to $1,000, Y is ready to exit the venture. • Y can sell to for $500, receive a liquidating distribution of $500, or some combination of each. Does it matter? (Ignore the collapse of XY if Y receives a liquidating distribution.)

34. Sale by Y to Z • On the sale, Y recognizes a gain of $400. Z takes a cost outside basis of $500 and a capital account of $100. Z enjoys a $400 inside basis adjustment under section 743(b). There is no effect on X, so if the property is then sold by the partnership, X will recognize a gain of $400. Z is protected by the 743(b) adjustment.

35. Distribution to Y • On the distribution, Y recognizes a gain of $400. There is a $400 common inside basis adjustment under section 734(b), so that when the asset is sold, the gain to X will equal $400 (amount realized of $1,000 less adjusted basis of $600). • Same basic result as the sale.

36. Distribution Followed by Sale • Suppose the partnership borrows $490, guaranteed only by X. The loan proceeds are distributed to Y, reducing Y’s interest in the venture from $500 to $10. Y then sells her remaining interest to Z for $10. • On the distribution, Y recognizes a gain of $390; on the sale, Y recognizes an additional gain of $10. Thus, for Y this offers no improvement.

37. Benefit to X • As a result of the leveraged distribution, the partnership is entitled to an inside basis adjustment of $390 under section 734(b). • On the sale of Y’s stub interest to Z, Z takes a cost basis of $10 and enjoys an inside basis adjustment of $205 under section 743(b). • When the asset is sold, there is a taxable gain of $410 (amount realized of $1,000 less cost of $200 plus 734(b) adjustment of $390).

38. Benefit to X: Continued • Of the taxable gain of $410, $205 is allocable to X and $205 to Y; Y’s share is offset by Y’s 743(b) adjustment. • If the debt is then repaid out of the sale proceeds, XY will own cash of $510. X’s capital account will equal $500 and Z’s capital account will equal $10. But X has been taxed on only $205 rather than on $400 (X’s outside basis is only $305).

39. What Happened? • When cash is distributed to a partner, any gain recognized by the distributee yields a common inside basis adjustment under 734(b) benefitting all the partners. This is a shifting of basis from the distributee to the other partners, for no net benefit: positive deferral for the other partners and negative deferral for the distributee. But then the distributee exits, ending the negative deferral.

40. Getting Into and Out of aReal Estate Partnership Howard E. Abrams Professor, Emory Law School www.taxnerds.com