United States

Partnerships with tax-exempt investors face a unique set of tax rules and traps for the unwary

INSIGHT ARTICLE  | 

The impact on depreciation
Under the depreciation rules of Internal Revenue Code section 168(h)(6)(A)(i), a partnership that has both tax-exempt and non tax-exempt partners and has nonqualified allocations to the tax-exempt partners must treat the tax-exempt partner's proportionate share of any depreciable property owned by the partnership as tax-exempt use property.

Qualified allocations: Basically, if a partnership has a tax-exempt partner and the allocations of each item of income, gain, loss, deduction, credit and basis are the same during the entire period that the investor is a partner in the partnership, the allocations are qualified. However, if the allocations are not qualified, a percentage based on the highest amount of any item allocated to the tax-exempt partner is applied to the property, and it is that portion which is deemed to be tax-exempt use property.

Many real estate partnerships are structured with a sponsor or carried interest. The sponsor will typically be allocated income after the equity partners have received their contributions back plus a stated return on investment. This arrangement is nonqualified, as the allocation is not pro rata to all the partners.

Caution: Many real estate investments are structured in tiers of partnerships. If one partnership in the tier has a nonqualified allocation, it will taint the chain and cause a portion of the property to have a longer life.

Tax-exempt use property: If the allocations are nonqualified, a portion of the property is classified as tax-exempt use property. The amount so classified is equal to the highest percentage that the tax-exempt investor could be allocated. Tax-exempt use property must be depreciated under the alternative depreciation system (ADS). Under ADS, the tax life for commercial or residential property is 40 years. Investors in commercial real estate won’t notice much of an effect, because the general depreciation system (GDS) tax life of a commercial building is 39 years. However, residential property has a GDS life of 27.5 years, which can cause a substantial difference in depreciation. Longer lives are also applied to personal property and other non-real property. Additionally, bonus depreciation may not be taken if the partnership is required to use the longer lives.

Note that only the portion of the property classified as tax-exempt use property is subject to the longer life and bonus limitations. The other portion of the property can be depreciated using GDS lives. Thus, there could be two different calculations for each asset. Once the total depreciation is calculated, it is then allocated to the investors like any other item of income or expense. A specific portion of depreciation from the longer lives cannot be allocated to the tax-exempt investors. All partners in the partnership are affected by these rules.

Illustrative example

DoGood pension fund, a tax-exempt entity along with three high net worth individuals (Able, Baker and Charles) and Dinero LLC (the sponsor) form a partnership called Gecco LLC to buy a residential property.

They invest the following amounts:

Gecco Investors Capital Contributions Capital Percentage
DoGood $34,000,000 85.00%
Able 2,000,000 5.00%
Baker 2,000,000 5.00%
Charles 2,000,000 5.00%
Dinero - -
  $40,000,000 100.00%

The partnership agreement allocates income and cash as follows:

  • The four equity partners receive a preferred return of 10 percent on their capital pro rata
  • The equity partners receive their capital back pro rata
  • Thereafter, 50 percent goes to Dinero and 50 percent to the rest of the partners pro rata

This is a nonqualified allocation; income and cash are not being allocated the same to the tax-exempt partner over the period that the tax-exempt is a partner in the partnership (i.e., DoGood is allocated 85 percent at first and then later 50 percent).

The highest percentage that the tax-exempt partner can be allocated is 85 percent. Thus, 85 percent of the property is tax-exempt use property.

Gecco must depreciate 85 percent of the property using the 40-year ADS life. The remaining 15 percent can be depreciated using the GDS life of 27.5 years, which Gecco chooses to do (note that Gecco can elect to depreciate the entire building using the ADS life).

Comparison of Depreciation, Year 1:

  Basis Depreciation
Expense
If allocations are nonqualified
27.5-year life 6,000,000 218,182
40-year life 34,000,000 850,000
  40,000,000 1,068,182
If allocations are qualified
27.5-year life 40,000,000 1,454,545
Difference 386,363
Individuals' share 15% 57,955
Tax impact to individuals
@ 35%
$20,284

Assumptions: All property is residential real property, the asset is placed in service on Jan. 1, 2011, and tax rate is 35 percent.

This illustration demonstrates that the individuals collectively lose current year deductions worth $57,955 because Gecco has nonqualified allocations. The impact over the life of the deal is even greater.

Comparison of Net Present Value (NPV) of Tax Benefit:

  Basis NPV of Tax
Benefit @ 35%
If allocations are nonqualified
27.5-year life 6,000,000 839,475
40-year life 34,000,000 3,547,572
  40,000,000 4,387,047
If allocations are qualified
27.5-year life 40,000,000 5,596,498
Difference 1,209,451
NPV tax cost to individuals $181,418

Assumptions: All property is residential real property, the asset is placed in service on Jan. 1, 2011, discount rate is 8 percent, and tax rate is 35 percent.

Over the life of the deal, the collective net present value of the lost tax benefit to the individuals will be $181,418.

Is there a solution, besides ensuring that all allocations are qualified, that can avoid this issue? One possible solution, which is less than ideal but may, in some circumstances, be a viable option, is to place an intermediary entity between the tax-exempt partner and the partnership. The tax-exempt partner would form a for-profit subsidiary corporation and have this entity be the investor in the partnership. This subsidiary would be treated as a tax-exempt controlled entity. The corporation would then make an election under section 168(h)(6)(F)(ii). This election exempts the entity from being treated as a tax-exempt entity, thus excluding it from the above mentioned depreciation rules. However, the election will cause the tax-exempt entity to have unrelated business taxable income from any gain on disposition of the corporation and any dividends or interest received or accrued from the corporation. A copy of this election should be attached to the tax-exempt entity’s 990 tax return.

Many individual or taxable entities may be unaware of the tax consequences that institutional investors can cause them, however inadvertent they may be. Also, lower-tier partnerships need to know if they have tax-exempt partners in the chain, so they can perform these calculations if required.

Sponsors should take care to inform their taxable investors of this issue. They need to be aware of the economic impact, as it could significantly affect their after-tax investment returns.

AUTHORS


Receive Tax Insights by Email

Subscribe


How can we help you with your tax planning & compliance?