Real Estate advisor. What you need to know about partnership allocations. July August Ask the Advisor

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1 Real Estate advisor July August 2014 Understanding rehabilitation tax credits What you need to know about partnership allocations IRS provides relief for mezzanine financing workouts Take your pick There s more than one way to execute a Sec exchange Ask the Advisor How should I assume the seller s loan? Baltimore 800 Red Brook Boulevard Suite 300 Owings Mills, Maryland Greater Washington, D.C Research Boulevard Suite 215 Rockville, Maryland Northern Virginia 1530 Wilson Boulevard Suite 700 Arlington, Virginia

2 Understanding rehabilitation tax credits What you need to know about partnership allocations In late 2013, the IRS released Revenue Procedure , which established a safe harbor clarifying how the agency will treat allocations of rehabilitation tax credits among partners. The procedure lays out circumstances under which the IRS won t challenge a partnership s allocation of credits to an investor/partner. Safe harbor requirements The safe harbor is available to two types of partnerships: 1. A developer partnership owns and restores a qualified rehabilitation building or certified historic structure. 2. A master tenant partnership leases a building from a developer partnership and elects to treat itself as having acquired the building for purposes of the rehabilitation tax credit. The entities will generally be eligible for the safe harbor if they satisfy these requirements: Minimum partnership interests. The principal in the partnership (the developer) must hold at least a 1% interest for the entire partnership term. The investor (the recipient of the tax credit) must hold at least a 5% interest for the taxable year in which the investor s percentage share is the largest. The credits must derive from qualified rehabilitation expenditures and such allocations must possess economic effect as provided within the 704(b) regulations. Bona fide equity investment. The investor s interest in the partnership must be a bona fide equity investment with a reasonably anticipated value commensurate with the investor s overall interest in the partnership. An investor s interest is a bona fide equity investment only if the reasonably anticipated value is contingent on the partnership s net income gain and loss and it isn t substantially fixed in amount. Plus, the investor must not be substantially protected from losses from partnership activities, and it must participate in the profits in a manner not limited to a preferred return. Arrangements to reduce value of partnership interest. The value of the investor s interest can t be reduced through arrangements (for example, fees or lease terms) that don t reflect arm s-length charges in other projects that don t qualify for credits. It also can t be reduced by disproportionate rights to distributions or issuances of partnership interests for less than fair market value. Minimum contributions. Before a building is placed in service, the investor must contribute at least 20% of its total expected capital contributions. That minimum contribution must be 2

3 maintained throughout the duration of the investment and generally may not be protected against loss through a guarantee or insurance arrangement with any person involved in the project. Contingency consideration. Before the building is placed in service, at least 75% of the investor s total expected capital contributions must be fixed in amount. The investor should reasonably expect to meet its funding obligations as they arise. Guarantees/loans. The safe-harbor qualification procedure limits the types of guarantees that may be provided to the investor by parties involved in the project. (See Is that guarantee permissible or impermissible? at right.) Plus, the investor can t get loans from the partnership or the principal, and the partnership and the principal can t guarantee or insure any indebtedness the investor incurs to acquire its interest. Purchase and sale rights. Neither the partnership nor the principal can have a call option or other right to buy or redeem the investor s interest in the future. The investor may not have a right to require anyone involved in the project to buy or liquidate its interest at a future date at a price exceeding its fair market value. Intent to abandon. The investor must not have acquired its partnership interest with the intent of abandoning it after the qualified rehabilitation is complete. Such intention is presumed if the investor abandons its interest at any time. Note that simply complying with these requirements won t ensure the validity of the tax credits. Is that guarantee permissible or impermissible? The new IRS safe harbor for rehabilitation credits isn t available if anyone in the rehabilitation project has entered into certain guarantee or insurance arrangements to protect the investor s minimum contribution against losses. Revenue Procedure specifically prohibits developers from providing guarantees of the investor s ability to claim tax credits or guarantees that the investor will receive distributions or consideration for its partnership interest. It also prohibits developers from indemnifying the investor for its costs if the IRS challenges the investor s claim of the credits. However, the procedure does allow unfunded permissible guarantees, which can include guarantees of or for the following items: Performing any acts required to claim the credits, Avoiding an act or omission that would result in the recapture of credits by the IRS because the partnership doesn t qualify, Completion, Operating deficit, Environmental indemnities, and Financial covenants. The procedure doesn t prohibit third-party guarantees or insurance from parties not involved in the project. The credits must also derive from qualified rehabilitation expenditures and such allocations must possess economic effect as provided within the 704(b) regulations. The regulation generally requires credits to be allocated to the partners in the same ratio that the partners share the partnership s taxable income for the year the property is placed in service, although future changes in income allocations are permitted. Follow the rules Revenue Procedure is effective for allocations of rehabilitation tax credits made after Dec. 29, If a building was placed in service before Dec. 30, however, and the safe harbor requirements were met at that time, the IRS won t challenge the allocation. As you can see, however, claiming rehabilitation tax credits is hardly simple. Make sure you work with your tax and real estate advisor to ensure the best results. n 3

4 IRS provides relief for mezzanine financing workouts The IRS has issued new guidance that will, in certain circumstances, exclude from gross income any discharged debt that s secured by the ownership interest in a disregarded entity. Revenue Procedure should help taxpayers with mezzanine financing in workouts and similar arrangements. How the issue arises Gross income usually includes income from the discharge of debt. But such income is excluded if, for any taxpayer but a C corporation, the debt is qualified real property business indebtedness (QRPBI). A requirement to qualify as QRPBI is that the indebtedness must be incurred or assumed by the taxpayer in connection with real property used in a trade or business, and it must be secured by such real property. The term secured by such real property isn t defined by the relevant law. While lenders commonly use mortgages to secure an interest in real estate, mortgages aren t the only form of security allowed. For example, in some instances, real property is owned by the borrower in an entity that s wholly owned and thereby disregarded for federal tax purposes but respected under state law as a separate and distinct entity. The mezzanine financing in such cases may be secured by the borrower s ownership interest in the respective entity. The IRS has recently noted that mezzanine debt secured by an interest in a wholly owned entity is also considered QRPBI so long as certain conditions are met. How to qualify for the exclusion Under the new IRS guidance, a safe harbor exclusion is available if: n The taxpayer or a wholly owned disregarded entity incurs debt, n The borrower owns 100% of the ownership interest in a separate disregarded entity owning real property (the property owner), and isn t the same entity as the property owner, n The borrower pledges to the lender a first priority security interest in the borrower s ownership interest in the property owner / disregarded entity, n At least 90% of the fair market value of the total assets directly owned by the property owner / disregarded entity is real property used in a trade or business, and any other assets held by the property owner / disregarded entity are incidental to the property owner / disregarded entity s acquisition, ownership and operation of the real property, and n Upon default and foreclosure on the debt, the lender will replace the borrower as the sole member of the property owner / disregarded entity. 4

5 Notably, if a taxpayer fails to meet these requirements, it s not precluded from arguing, based on facts and circumstances, that its debt nonetheless satisfies the secured by requirement. The amount that may be excluded from gross income is limited to the amount by which the outstanding principal amount of the QRPBI immediately before the discharge exceeds the fair market value of the real property. It s reduced by the outstanding principal amount of any other QRPBI secured by the property at the time of discharge. Applying the exclusion The exclusion is effective for taxpayers that make the required election regarding discharged debt on or after Feb. 5, Your financial advisor can help if you have questions. n Take your pick There s more than one way to execute a Sec exchange Section 1031 exchanges have been around for quite some time. They offer participants a way to dispose of property and subsequently acquire one or more other like-kind replacement properties as part of a nonrecognition transaction. The simplest type of exchange is a simultaneous swap of one property for another. Deferred exchanges are more complex but allow for additional flexibility. Here s how they work. Exchanging property Sec exchanges are named after Internal Revenue Code Sec. 1031, which allows you to exchange business or investment property (the relinquished property) for business or investment property of a like kind (the replacement property) without recognizing any gain or loss until the disposition or liquidation of the replacement property occurs. The provision also allows a deferred, or forward, exchange whereby the relinquished property is transferred before the acquisition of the replacement property. The replacement property must be identified within 45 days of when the relinquished property is transferred. The replacement property also must be acquired within 180 days of the transfer or by the due date of the applicable tax return (including extensions) for the year in which the relinquished property is transferred, if sooner (the exchange period). The same time limits apply to reverse exchanges. In a reverse exchange, the replacement property is acquired first and then parked with an exchange 5

6 It s important to note that a memo from the Office of Chief Counsel is specific to the particular facts that it addresses and has no precedential value. That said, it does provide a guideline for how to structure such a transaction. accommodation titleholder (the accommodator) before the relinquished property is transferred. Unwrapping the law In a memo from the Office of Chief Counsel (Memo No ), the IRS considered a scenario in which a taxpayer structured two separate exchanges. In the first, a reverse exchange, the replacement property was acquired and parked with the accommodator, and the taxpayer identified the relinquished property in a timely manner (within 45 days). The relinquished property had a much higher value than the replacement property, so the taxpayer planned to engage in a second exchange a deferred exchange to defer the gain that remained after the relinquished property was exchanged for the replacement property. A qualified intermediary (QI) was retained to execute the transfers of the properties in both exchanges. The QI followed all guidelines to ensure the taxpayer wasn t in constructive receipt of any of the exchange funds during the two 180-day exchange periods. The IRS memo concluded that, as long as the various guidelines are followed, the same relinquished property can be used in both forward and reverse exchanges even though allowing this structure could result in up to 360 days between the day on which replacement property is parked at the beginning of the reverse exchange and the day the deferred exchange is completed. Executing an example Imagine you decide to take advantage of property values and buy a property in California for $450,000 in January You park it with an accommodator so you can determine which property you d like to sell in order to reap the benefits of a reverse exchange. Within 45 days, you identify a property in New Jersey. In July 2014 within 180 days of parking the California replacement property you sell the New Jersey relinquished property for $1 million, completing the reverse exchange. The IRS memo concluded that, as long as the various guidelines are followed, the same relinquished property can be used in both forward and reverse exchanges. You begin executing a deferred exchange within 45 days, identifying additional like-kind replacement properties to buy with the remaining $550,000 of proceeds from the relinquished New Jersey property. And you have 180 days from the close on the New Jersey property to close on one or more identified replacement properties. So you don t have to close on those properties and complete the deferred exchange until January 2015 nearly a year after you bought the California property. Getting help To be certain, Sec exchanges can be a great way to take advantage of a weak commercial real estate market. But it s not a cakewalk. So work with your tax and real estate advisors to ensure you structure your next deal properly. n 6

7 Ask the Advisor How should I assume the seller s loan? The real estate market appears to be on the rebound, but sometimes it seems as if creditors haven t caught on to that. With the credit market still somewhat stingy, potential buyers may want to consider assuming their sellers loans. Not surprisingly, this approach comes with pros and cons. How it works Assumed loans are typically securitized, with strict requirements related to the borrower s structure. The lender will likely require that the buyer/loan assumer s structure mirror the entity described in the original loan documents. This means you may need to create a single-purpose entity (SPE) to carry out the transaction. If the loan documents require multiple levels of SPEs, you can usually satisfy lenders by forming a single-member limited liability company, with the buyer as the single member. You must obtain copies of all of the loan documents and closely review the terms and conditions. If you re confident that you can comply, contact the lender. The lender will provide an information package that, among other things, details the required deliverables and fees. Once you have the package in hand, complete an assumption application and make the necessary deposits. The lender also may require certain indemnification, as well as formation documents, biographical information on any principals and guarantors, the purchase agreement with the seller, tax data, and financial statements. Some loan documents include an assumption right that allows the initial borrower to transfer the property and loan to a buyer under specified circumstances. The lender will likely require the payment of a transfer fee (for example, 1% of the loan amount), payment of its legal and administrative expenses, and approval of your financial condition and expertise in real estate management. Pros and cons If a seller s loan documents provide the right to transfer the property and assign the loan, you shouldn t encounter many hurdles which will save you time and money. Loan assumptions can also save days and dollars because the process is often quicker than the loan origination process. And the existing loan may have more attractive rates and terms than you could secure in the current marketplace. But lenders generally have the last word on whether a buyer is qualified to take over a loan. Moreover, in the absence of an explicit assumption right, lenders can change loan terms. Look before you leap Before assuming a loan, closely scrutinize the loan provisions, loan assumption agreement provisions and any additional documents the lender requires. Then confirm that any changed loan terms are reflected in the necessary documents. n This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use REAja14 7

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