Novogradac Affordable Housing Tax Credit Conference Hotel Monteleone, New Orleans, La. May 15-16,

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2 Year 15 Dispositions & Capital Accounts Moderator: Charles A. Rhuda III Novogradac & Company LLP Thomas Morton Pillsbury Winthrop Shaw Pittman LLP Panelists: Barry Palmer Coats Rose Dave Sebastian Wentwood Capital Advisors Stephen Roger Affordable Housing Preservation Advisors LLC 2

3 Kinds of Year 15 Dispositions Sale of partnership interest Sale of all partnership interests to one person (Rev. Rul treats this as sale of property by partners) Sale of property by partnership Donation of partnership interest, including part giftpart sale 3

4 Early Buyout of LP Why does GP want LP to exit early? Why wouldn t GP want LP to exit early? Property has value, or will! Option to buyout LP for debt and exit taxes might be less before Y15 LP might demand lots of money Option to buyout LP in Y15 might be cheaper if LP capital projected to be close to zero Some LPs demand that the GP post a bond 4

5 Early Buyout of LP Why would LP want to leave early? Why wouldn t LP want to exit early? Property has no value; no point in sticking around Relieve yourself of asset management duties and other reporting requirements Accelerate some tax losses into year of exit and/or potentially avoid exit taxes Property has lots of value! Early exit might forfeit that value Don t trust GP to keep property compliant Exposure from extending the statute of limitations 5

6 Right of First Refusal Under IRC 42(i)(7) nonprofits often can purchase the property for: Partnership debt; plus Exit taxes which includes: Phantom income from negative capital account State and local taxes attributable to sale If taxes don t exist, then just assume debt 6

7 Qualified Contracts Qualified contracts can be exceptionally complex IRC 42(h)(6)(F) and Treas. Reg don t answer all of the questions of qualified contracts California regulatory agreement does not provided for qualified contract option 7

8 Year 15 Disposition Consequences Two aspects of dispositions to remember: Cash Exit Taxes Allocation of cash distribution dependent on capital accounts which is affected by gain/loss allocation Different tax rates can apply to different kinds of income or gain. 8

9 Tax Issues to Remember Capital Gain vs. Depreciation Recapture vs. Ordinary Income Distributions in Accordance with IRC 704(b) Capital Accounts Nonpayment of Deferred Fees Installment Sales Partnership Termination 9

10 Capital Gain v. Depreciation Recapture v. Ordinary Income Corporations generally pay the same 35% federal rate on all three Individuals pay different federal rates as follows: Capital gain 20% Straight-line depreciation recapture 25% Accelerated depreciation recapture 39.6% Receivables treated as hot assets under IRC % Applies even if the partnership interest (rather than partnership assets) is sold. 10

11 Example of Tax Rates on Property Sale Suppose the property originally cost $4M. Fifteen years later it has been depreciated to $2.2M. The sales price is $5M. So, we have $2.8M of gain (that is, $5M less $2.2M) For a corporate partner, the tax rate is 35%, or $980K For an individual partner, the tax rate is 25% times the depreciation recapture and 20% times the capital gain Original price less current basis is depreciation recapture. That s $4M - $2.2M, or $1.8M. At 25%, that s $450K of tax, plus Sales price less original price, which is capital gain. That s $5M less $4M, or $1M. At 20%, that s $200K. Total tax bill is $450k + $200K, or $650K. 11

12 IRC 704(b) Capital Accounts Capital accounts adjustments include: Partner s investment (increase) Share of profits (increase) Contributions (increase) Losses (decrease) Syndication costs (decrease) Distributions (decrease) 12

13 IRC 704(b) Capital Accounts Continued IRS requires that on liquidation, distributions must be made in accordance with capital accounts. Treasury Regulation (b)(2)(ii)(b)(2) indicates that cash is distributed according to positive capital accounts. 13

14 When is a waterfall not a waterfall? Partnership Agreement says: Waterfalls govern cash splits of a sale BUT IRS says that liquidation allocations be made in accordance with the positive capital account balances of the partners. 9.2.B (Proceeds from Sale or Refinance) is subject to 12.4 (Liquidation) 12.4 says on liquidation: after payment of Liabilities BUT before the final splits, balance of PA assets of the Partnership shall be distributed according Partners capital account balances. determined AFTER all allocations for the year during which the liquidation occurred have been made. Must calculate LP capital account after sale of property (and allocation of all book profits from sale) 14

15 Capital Accounts IRC 704(b) issue 704(b) Issue!!! Risk Strategies to Reduce Risk LP cannot claim losses & credits Investor in turn cannot claim losses & credits Deferred developer fee (DDF) disaffiliation Allocate losses to the extent of operating deficit to GP Create income Write off liabilities (DDF expected to be paid?) Deficit restoration obligations (Last resort) 15

16 Maintenance of Capital Accounts and Substantial Economic Effect The foregoing provisions and the other provisions of this Agreement relating to the maintenance of Capital Accounts are intended to comply with Treas. Reg (b), and shall be interpreted and applied in a manner consistent with such regulations. It is the intention of the Partners that the Capital Accounts maintained under this Agreement be determined and maintained throughout the full term of this Agreement in accordance with the accounting rules of Treas. Reg (b)(2)(iv). 16

17 Reasons LP s Capital Account may be Positive Little or no excess basis in property Project is in DDA or QCT Financing is mostly equity Property has little or no losses Don t have loans that accrue unpaid interest 17

18 Reasons LP s Capital Account may be Negative Excess basis in property Tax-exempt bond project Low credit price Many financing sources Property has big losses often including accrued but unpaid interest Bonus depreciation 18

19 The Good Capital Accounts Pre Sale GP LP Capital Account Prior to Sale $ (25,000) $ (575,000) 19

20 The Good The Sale Sales Price $ 8,450,000 Fixed Assets $ 7,600,000 Less Acc. Depreciation (4,750,000) $ 2,850,000 Land 100,000 Basis 2,950,000 Gain (Loss) on Sale $ 5,500,

21 The Good Cash to Distribute Sales Price $ 8,450,000 Mortgage - 3,450,000 Transaction Costs - 100,000 3,550,000 Cash to Distribute $ 4,900,

22 The Good (Because 90/10 Cash Split Satisfied) GP LP Total Capital Account Prior to Sale $ (25,000) $ (575,000) $ (600,000) Gain on Sale: $5,500,000 Gain Alloc. to Offset Negative Capital 25, , ,000 Capital Account After Initial Alloc Gain Alloc. to Follow Partner Split 4,719, ,385 4,900,000 Gain Reallocation For LP Exit Taxes* (Assume 35%) (309,615) 309,615 - Capital Account Before Liquidating Distribution 4,410, ,000 4,900,000 Cash Distributed 4,410, ,000 4,900,000 Cash Split 90% 10% 100% *Exit tax based on negative LP capital (also includes tax on distributions for exit tax) 22

23 Calculations to Determine LP s Exit Tax Total Gain Including Exit Tax Tax Rate Exit Tax 575,000 35% 201, ,250 35% 70, ,688 35% 24, ,341 35% 8, ,969 35% 3, ,989 35% 1, ,046 35% ,416 35% 129 Additional iterations are not shown Exit Tax 309,

24 Alternative LP Exit Tax Calculation Gain Divided by (One Less Tax Rate) 575,000 / (1 -.35) = 884,615 Less Phantom Income (575,000) Exit Tax 309,

25 LP s Schedule K-1 (575,000) - 1,065, ,000 - X 25

26 The Not-So-Good Capital Accounts Pre Sale GP LP Capital Account Prior to Sale $ (25,000) $ 2,300,

27 The Not-So-Good Sales Price $11,300,000 Fixed Assets $11,500,000 Less Acc. Depreciation (3,825,000) $ 7,675,000 Land 1,700,000 Basis 9,375,000 Gain (Loss) on Sale $ 1,925,

28 The Not-So-Good Sales Price $ 11,300,000 First Mortgage $ 6,750,000 Second Mortgage 250,000 7,000,000 Transaction Costs 100,000 7,100,000 Cash to Distribute $ 4,200,

29 The Not-So-Good Because 90/10 Cash Split Not Fully Satisfied GP LP Total Capital Account Prior to Sale $ (25,000) $ 2,300,000 $ 2,275,000 Gain on Sale: $ 1,925,000 Gain Alloc. to Offset Negative Capital 25,000-25,000 Capital Account After Initial Alloc. - 2,300,000 2,300,000 Gain Alloc. to Follow Partners Split 1,900,000-1,900,000 Gain Reallocation For LP Exit Taxes (Assume 35%) Capital Account Before Liquidating Distribution 1,900,000 2,300,000 4,200,000 Cash Distributed 1,900,000 2,300,000 4,200,000 Cash Split 45% 55% 100% 29

30 LP s Schedule K-1 2,300, ,300,000 - X 30

31 The Ugly Capital Accounts Pre Sale GP LP Capital Account Prior to Sale $ (450,000) $ (1,500,000) 31

32 The Ugly Sales Price $ 8,800,000 Fixed Assets $14,000,000 Less Acc. Depreciation (7,800,000) $ 6,200,000 Land 600,000 Basis 6,800,000 Gain (Loss) on Sale $ 2,000,

33 The Ugly Sales Price $ 8,800,000 First Mortgage $ 7,635,000 Second Mortgage(s) 1,015,000 8,650,000 Transaction Costs 100,000 8,750,000 Cash to Distribute $ 50,

34 The Ugly (Because GP Contributes Cash) GP LP Total Capital Account Prior to Sale $ (450,000) $ (1,500,000) $ (1,950,000) Gain on Sale: $ 2,000,000 Gain Alloc. to Offset Negative Capital 450,000 1,500,000 1,950,000 Gain Alloc. to Follow Partner Split 50,000-50,000 Gain Reallocation For LP Exit Taxes* (Assume 35%) (807,692) 807,692 - Capital Account Before Liquidating Distribution (757,692) 807,692 50,000 Cash (Contributed) Distributed (757,692) 807,692 50,000 Cash Split -1,515% 1,615% 100% *Exit tax based on negative LP capital (also includes tax on distributions for exit tax) 34

35 Calculations to Determine LP s Exit Tax Total Gain Including Exit Tax Tax Rate Exit Tax 1,500,000 35% 525,000 2,025,000 35% 183,750 2,208,750 35% 64,313 2,273,063 35% 22,509 2,295,572 35% 7,878 2,303,450 35% 2,757 2,306,208 35% 965 2,307,173 35% 338 Additional iterations are not shown Exit Tax 807,

36 Alternative LP Exit Tax Calculation Gain Divided by (One Less Tax Rate) 1,500,000 / (1 -.35) = 2,307,692 Less Phantom Income (1,500,000) Exit Tax 807,

37 LP s Schedule K-1 (1,500,000) - 2,307, ,692 - X 37

38 Nonpayment of Deferred Fees Suppose that it s year 15, and the development fee is unpaid. The IRS may dispute if the development fee is eligible basis. GP will often have to pay development fee as capital contribution by year 13 (IRS TAM ). Developer (often also the GP) receives the cash back as payment Developer recognizes income No change in net cash for Developer (if also the GP) Losses could be allocated to GP to offset income 38

39 Year 15 Dispositions & Capital Accounts Moderator: Charles A. Rhuda III Novogradac & Company LLP Thomas Morton Pillsbury Winthrop Shaw Pittman LLP Panelists: Barry Palmer Coats Rose Dave Sebastian Wentwood Capital Advisors Stephen Roger Affordable Housing Preservation Advisors LLC 39