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Accelerated Depreciation on Steroids ๐
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We're going deep real estate niche today - but with a purpose: to illustrate the power of timing in tax strategy. Real estate partnerships are powerful for several reasons, but the primary one is the ability to use debt on the property as basis for the owners and investors. But the thing about debt is that it's not created equal. ๐ โโ๏ธ Debt can be:
If you want more details - see this prior email. And over the life of a property, the classification of debt can change - which in turn changes the basis of the partners. For example, when a property is being developed (built) many times the loan is recourse to the general partners (GPs) of the entity. This makes sense because it's a much riskier time for the lender since the property isn't making any money. But once the property is built and leased up (stabilized), the debt usually gets refinanced and those guarantees removed. At this time, the debt is likely Qualified Nonrecourse - shifting basis away from the GPs and to the LPs. This has massive implications for which partner gets allocated losses between the two types of debt. Losses in partnerships follow "economic risk of loss" - which practically speaking usually means that the equity contributed is allocated losses all the way down to $0, and then the allocation of liabilities drives who gets the remaining losses. That means that when the deductions are taken is as important as how much deductions are taken. Two real-life scenarios to illustrate the power of timing this decision: Promote Crystallization ๐ฎ
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For the uninitiated, a "promote crystallization" clause in an operating agreement allows the GP to trigger a "step-up" in equity in the property and stop paying "preferred returns" (pref). The logic is that the pref is to compensate the limited partners (LPs) for early risk in the property. But once the property is stabilized, that risk is mostly gone and the GP should be eligible for a higher participation in the income - having proved their worth.
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While equitable - and a worthwhile provision - it can create phantom income to an unwary GP. ๐ป Especially if the operating agreement includes target capital allocation language (most do), then the GP will pick up income to the extent of the "value" of the crystallization of equity he receives. Note that he's only received equity for this - no cash.
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But not all is lost. When these clauses happen, we will often advise our clients to delay a cost segregation study until the year of promote crystallization. With an increase in basis via the taxable step-up in equity, the GP can get more depreciation allocated to them and help mitigate (or wipe out, in some cases) the phantom income impact.
โ โ๏ธ And now, a shameless plug (badum tss) - I've put together a deeper dive on 6 powerful tax strategies for real estate pros and investors. These should be on your checklist when reviewing real estate partnership returns to know how these were considered. ๐
โ Preference to the LPs ๐ฉ
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The amount of asset that you can take accelerated depreciation on is determined when you place it in service - not the year you do the cost segregation study.
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So for every GP that wants to grab all the depreciation early, there's another one playing the long game - waiting until the asset is stabilized and refinanced so the LPs get more in basis (as Qualified Nonrecourse is allocated to all partners) and can participate more in depreciation.
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Through the magic of Minimum Gain, a year when the property is refinanced can produce an LPs favorite type of K1: massive distributions + massive losses. ๐ซ
By using the right mix of timing + a cost segregation + debt, K1s can swing wildly for the GPs and LPs. Dialing in exactly what expectations are and how to achieve that is more art than science when multiple levers work together. ๐๏ธ This same sort of swing can be duplicated across different types of income and expense events in varying industries as well as for individual taxpayers. The name of the game is always "matching." The timing of the taxable event โฅ the taxable event itself. ๐ซก ๐ฅ Hottest Finance Posts This Week ๐ฅโ
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