The information presented here is intended solely for informational purposes and should not be construed as accounting advice from the author or Reznick Group. Reznick Responds will run every other month, so be sure to send accounting questions that you would like to have addressed in this column to email@example.com.
Q I am the general partner of a property that started taking tax credits in 1991. The property needs renovation, and I want to continue to manage the property. What factors should I consider as the property comes to the end of the compliance period?
A As the general partner, you must consider your fiduciary responsibilities to your partners. In some cases what would be in your best interest may not be in the best interest of the other partners. The first question is “Should the property be sold?” The starting point is to make a realistic assessment of the fair market value of the property in its current condition. You may want to consult a real estate broker who specializes in the sale of affordable housing properties to determine the potential sales price of the property.
In some real estate markets the demand for a property, even with extended low-income housing restrictions in place, could make a third-party sale the most attractive option. If the property is going to be sold to a new partnership that will qualify for acquisition low-income housing tax credits (LIHTCs), the buyer must be sufficiently unrelated to the seller. In either case, if the property will be sold you must determine the benefits to all the partners of the seller.
The partnership agreement determines what rights and responsibilities the partners have if the property is sold. The partnership agreement will specify how sales proceeds and gains from the sale are to be allocated among the partners. Partners are interested in how much net proceeds they will receive from the sale. Net proceeds are the combination of the cash distributed from the sale less any taxes due or plus any tax savings from the sale of the property and liquidation of the partnership.
Sales proceeds available for distribution to the partners are cash received from the buyer less all liabilities that must be paid. In most cases, the mortgage debts on the property must be paid. If the property has substantial soft financing, all the cash from the sale may go to the lenders, leaving no cash to distribute to the partners. Under certain circumstances a lender, such as a municipality, may agree to write down a debt to facilitate the sale of the property to a buyer that is willing to renovate and extend the period of low-income affordability. The write-off of the debt could increase the taxable income of the partnership, but it would also free up more cash to be distributed to the partners.
Another possibility is that there are loans from related parties and fees payable that would be paid prior to distributions to partners. The partners receiving these payments are likely to view the transaction more favorably than the ones waiting for a distribution. Many early tax credit deals provided that residual sales proceeds were first to be distributed to the limited partner until it received a full return of its initial capital contribution, and then split between the general and limited partners. In this scenario, the general partner would probably not get much, if any, cash on sale. All these variables need to be analyzed to decide if a sale of the property makes sense.
Distributions to a partner that are at least sufficient to pay its tax liability may be critical to obtaining the needed approvals to sell the property.
The actual tax effects of a sale for each partner are impossible to determine at the partnership level because of the complexity of the alternative minimum tax, the passive-activity rules, and the interaction of capital gains and losses.
It is possible to do a rough estimation of the taxable income and tax liability if the property will be sold and the partnership liquidated. A partner’s taxable income can be estimated by taking its tax capital account prior to sale and reducing it by the sales proceeds distributed. If the result is a positive number the partner has a tax loss, and if the number is negative then the partner has taxable income. An example of this calculation may be helpful:
In this example, the sales proceeds of $250,000 distributed are less than the estimated federal tax liability of $280,000. Numerous factors can complicate this analysis, including the character of the gain and the timing of income recognition, so each partner should consult its tax advisor to determine the more precise tax impact of the transaction. Because the tax liability of the partners is only one of the factors in a partner’s decision to approve or seek the sale of the property, partners should discuss options early in the decision-making process. Some limited partners may be interested in having the general partner acquire their partnership interest as soon after the end of the compliance period as possible, rather than waiting for the sale of the property.
Sale of limited partner’s interest
The sale of a limited partner’s interest to the general partner may be an attractive option to all of the parties involved. Because this type of sale is a negotiated transaction, the provisions in the partnership agreement do not dictate the outcome. The underlying value of the real estate and potential distributions from operations, sale or refinancing will have some bearing on the sales price of the interest, but they are not the sole determining factors.
The limited partner may be interested in recognizing a tax loss if it has a positive capital account, or it may be interested in freeing up passive losses if the limited partners are individuals. Ongoing book losses from the investment may have a negative impact on the financial statements of a limited partner that is a corporation so it could be attractive to sell the interest, or the limited partner may want to be relieved of continuing oversight of the investment. There are also advantages for the general partner to buy out the other partners in the deal.
The general partner that buys out the other partners takes total control of the deal and can decide the future course of action without possible conflicting priorities. The purchase should be structured to avoid the termination of the partnership, which means that there need to be at least two partners at all times. Earlier this year, the Internal Revenue Service released Private Letter Ruling 200502019, which clarified that a technical termination of the partnership because of the sale of a greater than 50% partnership interest would not cause a new placed-in-service date for purposes of the 10-year rule for acquisition credits. The general partner would preserve the right to sell the property to a new LIHTC partnership that would be able to claim the acquisition credits, assuming the other requirements for the credits are met. Other possible benefits to the general partner include the elimination of limited partner reporting and financial statement audit requirements, control of cash flow, sales proceeds and refinance proceeds.
The owners of LIHTC properties coming to the end of the 15-year compliance period have an opportunity to transfer the property or their ownership in the property without recapture. Savvy owners are looking at a number of possibilities, including the ones described above. Open dialogue among the partners can result in a course of action that is beneficial for everyone. As always, you should consult knowledgeable professionals who can identify issues that are particular to your transaction. n
Reznick Group has more than 25 years of experience providing accounting, tax and business advisory services to clients nationwide. The expertise of the firm is broad, ranging from real estate and management advisory to auditing and tax preparation. Ranked among the top 20 public accounting firms in the nation, Reznick Group is on the move – continuing to grow nationally, expanding its services, and building upon its leadership as industry experts.
Beth Mullen is a principal in the Real Estate Consulting Group of Reznick Group, based in Sacramento, Calif.
The owners of LIHTC properties coming to the end of the 15-year compliance period have an opportunity to transfer the property or their ownership in the property without