Real Estate Investment Groups Can Maximize Value through Sophisticated Tax Planning
IMGCAP(1)][IMGCAP(2)]Real estate partnerships pool funds from various investor groups, family offices and public entities to invest in property platforms seeking high cap rates and strong yields. Even though the investors within each fund have different tax structures and tax needs, the goal of enhancing each investor’s rate of return can be accomplished through sophisticated tax planning strategies.
When entering funds into a real estate partnership, the focus is typically on preserving the tax exempt status for the public investors. This focus on the tax exempt partner side of the arrangement can distract the typically smaller investor group, the taxable partners, from incorporating and maximizing their own tax opportunities into the partnership structure.
Special tax allocations and accelerated depreciation deductions stemming from cost segregation studies are two examples of traditional tax savings strategies that are often overlooked or typically not thought to be beneficial due to the heavy concentration of tax exempt partners within the structure. With proper tax planning upfront, both the tax exempt and taxable partners can gain tremendous shifts up in the cap rate.
Examining the opportunity within these partnerships for better investor ROI leads to running the cap rate models contemplating cost segregation studies and accelerated depreciation deductions in a bifurcated structure, presenting much greater returns for both investor groups.
As most investors are aware, cost segregation studies often focus on buildings and building components and other tangible property and land improvements. These studies break larger building components and tangible property into smaller units of property that have a shorter tax life than the building structure itself. This allows the taxpayer, for tax purposes, to recover the cost of components via depreciation deductions over a shorter time period than otherwise allowable, thus creating wealth and cash preservation for active taxpaying investors.
The IRS has historically taken the position that components of a building could not be separately depreciated. Having lost several court cases, the government recently issued regulations allowing separate depreciation for building components. These regulations not only confirm that component depreciation is allowable, they also provide a framework for identifying costs associated with buildings and other property that, for tax purposes, are considered deductible repairs, capital improvements and taxable dispositions for which gains and losses can be taken.
These regulations also provide a number of new rules that all taxpayers must comply with for tax years beginning on or after 2014, safe harbors that may apply, and optional elections that taxpayers can make. The government has recently issued administrative guidance explaining how taxpayers are to implement these rules. The updated rules make it easier to change longstanding and inefficient tax positions. This presents a prime opportunity for all taxpayers to re-evaluate their existing tax positions.
This is particularly true for partnerships that have tax exempt retirement partners that may have overlooked or passed on more traditional tax planning such as cost segregation studies.
In general the private taxpaying investor group represents a smaller portion of traditional real estate investment groups. The cost segregation helps this minority by generating greater depreciation deductions to reduce the tax on their rental income and, in some cases, reduce the tax on other income if they are considered active real estate investors. Tax exempt partners, on the other hand, generally do not benefit from depreciation deductions. Thus, in some cases, the differing status of the two groups can present a prime opportunity to specially allocate the tax exempt partners’ share of depreciation deductions to the taxable partners. By doing this intelligently, the tax exempt partners can also greatly benefit due to the fact that this would dramatically reduce any back-end recapture to the tax exempt entity upon the sale of the asset, which dramatically improves their return position.
Partnership tax laws allow partners to divvy up the financial benefits and burdens of the partnership among themselves as they see fit. These laws allow the partnership to allocate items including income, deduction and expense to individual partners. For example, the partnership agreement may provide that tax depreciation is allocated to one partner and, in lieu of tax depreciation, additional income is allocated to the other partners. In such a scenario, the tax exempt partner would greatly benefit from the minimization of recapture while the taxpaying partners gain equal benefit in the accelerated tax deductions at their federal tax rate while saving on recapture at the capital gain rate spread.
If properly structured, the tax exempt and taxable partners both may benefit from the special tax allocations. For example, the special tax allocation may be structured so that the tax exempt account partners receive more cash distributions upfront to distribute as retirement income to the retirement account owners in lieu of their allocable depreciation deductions. At the same time, the special tax allocation may be structured so that the taxable partners receive more of the partnership tax depreciation deductions. When coupled with a cost segregation study, the taxable partners may even be able to receive the depreciation deductions sooner rather than later. The benefit to both investor groups is meaningful and enhances wealth preservation for both groups.
These special tax allocations are typically respected by the IRS as long as the allocations meet the requirements of the Sec. 704 special tax allocation rules. There are a number of nuances that must be met to comply with these rules, which generally require the partnership to keep accurate accounting records reflecting the investment and distributions to each partner and include language in the partnership agreement that would essentially prevent the partners from exiting the partnership with a benefit in excess of their respective investments in the partnership. The terms, timing and circumstances of when the special tax allocations are incorporated into the agreement must be considered when planning for these special tax allocations, as must the rules that preserve the tax exempt status of the retirement account partners.
Real estate investment partnerships structured to accommodate tax exempt account partners may have foregone traditional tax-planning opportunities. Special partnership allocations and cost segregation studies are common examples of missed strategies that, if applied carefully, could benefit both tax exempt and taxpaying investors in these partnerships. These common techniques can produce significant tax efficiencies. With the recent changes to the depreciation rules, now is an ideal time for partnerships to reconsider their tax positions and implement changes that take advantage of these rules to create win-win scenarios that benefit all of their investors.
Julio Gonzalez is CEO of Engineered Tax Services, an engineering firm that performs cost segregation studies, and tax attorney Kreig Mitchell serves on the firm's advisory board.