Hidden Flexibility in Nonrecourse Deductions for Real Estate Partnerships
November 05, 2021
By Michael Torhan
Managing members of closely held partnerships as well as sponsors and general partners of large real estate funds should all consider how certain language in operating agreements impacts the allocations of profits and losses to partners. One of the largest positive tax attributes of the partnership structure is the flexibility afforded partners, including how to structure the economics of business arrangements. Such flexibility is also one of its largest negative tax attributes due to the complexity and nuances that are involved in the administration and tax compliance for partnerships.
Real estate partnerships, whether closely held friends and family partnerships, joint ventures, or large real estate funds, are all impacted by the complex income and loss allocations required when operating under the partnership tax construct.
One such partnership concept relates to “nonrecourse deductions” which are generally driven by depreciation. An awareness and consideration of how operating agreement language relating to such deductions drives allocations between partners will allow managers and general partners to have the required background needed to structure appropriate partnership arrangements suitable for themselves and their investors.
Overview of Targeted Capital Allocations
Many joint ventures and real estate partnerships provide for an allocation of profits and losses following a targeted capital account approach. This methodology states that net income and net losses for the year are allocated such that the resulting year-end capital account of each partner is as nearly as possible equal to the distributions that would be made to such partner under the partnership agreement in a hypothetical liquidation of the entity, if all the assets were disposed of at book value. In computing allocations, an adjustment is made to each partner’s “targeted” capital for their share of “minimum gain,” which is discussed later.
Allocations must have substantial economic effect to be respected. The partners receiving loss allocations must bear the burden of those losses. In a waterfall where equity and preferred return are returned first, or alternatively an IRR is paid first (which inherently includes both a return of capital as well as a return on capital), tax losses are generally allocated to the common (non-preferred) partners in accordance with their positive capital accounts. This result occurs because they are deemed to bear the burden of such losses since the preferred partners have priority to receive cash under the distribution waterfall. After the common partners’ capital accounts are reduced to zero, the losses are then allocated to the preferred partners until their capital accounts are reduced to zero.
Once book capital accounts are reduced to zero (for simplicity purposes, this assumes an entity only has real property and debt), members cannot technically bear the burden of further losses since they no longer have book capital. Theoretically, a lender bears any economic burden that corresponds to those allocations which are funded by debt. This is where minimum gain is generated.
Minimum gain is the excess of debt over the tax basis of property. Explaining minimum gain through an example: If members contribute $20 and use debt of $80 to purchase a property for $100, they bear the burden of the first $20 of losses (i.e., through depreciation). At this point, their tax capital would be down to zero. Additional tax depreciation of $10 would create minimum gain since the debt of $80 would exceed the basis of $70 ($100 less $30 of accumulated depreciation). The name “minimum gain” comes from the tax principle that on liquidation, $80 of debt would be relieved against $70 of basis thereby producing $10 of gain; and as such, the “minimum gain” triggered on a deemed liquidation.
Tax regulations provide that the $10 of tax depreciation deductions are called nonrecourse deductions. Further, the regulations state that the partnership agreement must provide for allocations of such nonrecourse deductions in a manner that is reasonably consistent with allocations of some other significant partnership item (and that have substantial economic effect) attributable to the property securing the nonrecourse liabilities. This provision provides flexibility to partners in how the nonrecourse deductions are allocated.
An example in the regulations states that in a 90%/10% LP/GP partnership where profits are allocated 50%/50%, the allocation of the nonrecourse deductions 75% to LP and 25% to GP (or in any other ratio between 90% to LP/10% to GP and 50% to LP/50% to GP) would satisfy the consistency requirement mentioned above.
In many partnership agreements, boilerplate language is included that states that nonrecourse deductions are allocated in accordance with ownership percentages (e.g., capital contribution ratios), however these types of allocations can create distortions. The allocation of nonrecourse deductions in other ratios (that meet the consistency test) may be more appropriate.
Potential Distortion Created by Nonrecourse Deductions
As an example, in the real estate fund context where limited partners contribute 95% of capital and a general partner contributes 5% of the capital, there may be a point in the lifecycle of the fund that all capital and preferred return will have been returned back to investors. Thereafter, the fund will be operating in the promote tier of the waterfall. For example, in an 80%/20% waterfall, future distributions would be distributed 76% to limited partners (95% of 80%) and 24% to the general partner (5% of 80% + 20%).
In such a scenario, the use of boilerplate language where nonrecourse deductions are allocated in accordance with original capital ratios may create distortions. If the remaining properties of the fund were subject to the minimum gain rules mentioned above (i.e., where debt exceeds basis), nonrecourse deductions attributable to such properties would be allocated using original capital percentages even though all other allocations would potentially follow the 76%/24% ratio (subject to complex computations under the hypothetical liquidation approach which are outside the scope of this article).
If, however, the nonrecourse deduction provision of the operating agreement provided that nonrecourse deductions are allocated in proportion to each partner’s percentage of promote profits, such distortion could potentially be partially or completely alleviated.
An analysis and review of the nonrecourse deduction language in an operating agreement is appropriate for both newly contemplated partnerships as well as existing entities. Clearly, managers and general partners creating new partnerships have an incentive to understand how tax provisions will drive future allocations of deductions for partners.
For existing partnerships, the tax code provides partnerships with some flexibility to make modifications to existing agreements. The tax code states that a partnership agreement includes any modifications of the partnership agreement made prior to, or at, the filing deadline of the partnership return for the taxable year (not including extensions) which are agreed to by all the partners, or which are adopted in such other manner as may be provided by the partnership agreement.
Therefore, a partnership agreement made be amended prior to the original filing deadline of a tax return (i.e., March 15). For partnerships that have not yet generated nonrecourse deductions, this flexibility may provide an opportunity to analyze existing provisions and potentially make amendments in anticipation of future nonrecourse deductions.
It should be noted that any increase of a deduction allocation to a partner means a corresponding decrease of deduction allocation to another partner. All implications of how nonrecourse deductions are allocated should therefore be considered by keeping all partners in mind. Due to the complex nature of partnership tax accounting, consultation with tax advisors is recommended so that all scenarios are considered and evaluated.