I've been a CPA for nearly 20 years - serving private small business and real estate the entire time. I take the lessons learned in serving and now running a small business and share them here. For business owners, investors, and advisors looking to lower their cost of capital, subscribe for delivery straight to your inbox ๐ Also on YouTube at PlugAccountingandTax!
Debt: the Ultimate Tool in a Partnership
|
๐ง Before we jump in - be sure to listen to Today in Tax Court: Gregory v. Helvering. It's the newest episode and I cover this landmark case on entity structure and business purpose doctrine. ๐ง โ
If you've been following me for a while, you'll know I preach that a core input of entity selection is what the balance sheet will look like. In general, you do not put appreciating assets in a S-Corp without very good reason. ๐ โโ๏ธ That maxim becomes even truer when that appreciating asset is subject to a liability (bank loan / mortgage). I usually advise that appreciating assets subject to liabilities belong in partnerships - today we'll get a little into why. And along the way we'll talk a little tax history and theory. Buckle up and let's dig in๐บ โ 1986 - A Turning Point in Tax Planning The name of the game in tax planning for wealthy people, prior to 1986, was tax shelters. ๐ If you had enough money to spend, you could find an investment that would generate outsized losses that you could then take against your income you earned (W2 or otherwise - think STR on steroids ๐). Given, the investment structure and purpose must still hold water as a non-strictly tax-motivated transaction. But that was really the only battle you had to fight. You can't really blame people for this - as the top marginal tax rate in the 1940s - early 1980's ranged from 50% to 94%. ๐ฐ Entire industries existed just to shill you on tax shams - and people made (and "saved") a lot of money. But it resulted in a lot of abuse. ๐ค โ Enter in At-Risk and Passive Limitations To address this, in 1986 the IRS introduced two new limitations (beyond the business-purpose doctrine) referred to as ยง465 and ยง469 (nice ๐). ยง469 is the passive activity rules that most investors are familiar with. It's outside of this week's email's scope - but in short it limits passive losses to passive income. So the rich people were now stuck only being able to use those juiced-up losses against their passive income. ๐ธ ยง465 is very much in scope this week - it's the At-Risk limitation. And it's what makes partnerships ideal for holding assets subject to liabilities. ๐ At-risk limitation basically says that if a partner's basis isn't at-risk of loss, then the losses generated with that basis are limited. So what's "At-Risk"? Capital contributed (usually cash), recourse debt, AND qualified non-recourse debt. โ โ โ What's NOT "At-Risk"? Nonrecourse debt. โ โ Recourse or Non-recourse, That Is the Question From these rules, we now have three types of debt to report on a partner's K1: Before we get into each one, remember that this isn't at all possible with a S-Corp. Meaning, if an S-Corp has a bank loan - the shareholders cannot benefit from basis in that loan. ๐ฆ They cannot use losses generated with that bank loan and offset other income with those losses because liabilities do not increase basis for a S-Corp shareholder - guarantee or not! ๐ But liabilities do increase basis for a partner. Hence this email. ๐คทโโ๏ธ Nonrecourse Debt is a liability that no partner is personally liable for. There is no guarantee by anyone, and if the partnership doesn't pay, the bank can't come after partners personally. This basis is not "at-risk" and so any losses generated by this kind of debt can be limited by the ยง465 rules. Recourse Debt is a liability that one or several partners are personally liable for. They have a guarantee for that liability - wholly or partially. As such, the amount of the loss they may sustain is considered "at-risk" and they get credit for that guarantee as recourse debt. Qualified Nonrecourse Debt is where the magic happens. This is debt that (paraphrasing regs) is from a bank, no one guarantees, is not convertible, and is borrowed with respect to holding real property. But even though no one guarantees the liability, it's considered "at-risk." Just one of the several ways real estate is favored by the tax code. ๐จ๐ปโ๐ฆฐ โ What Does It All Mean Putting it all together - we like when taxpayers get credit for something they are not personally liable for. ๐ซ In real estate, Qualified Nonrecourse Debt can be teamed up with accelerated depreciation and Minimum Gain rules to generate the same outsized losses our grandparents were chasing - and keep it all legal. ๐ Let's walk through an example to close out on: Partners A, B and C buy a building for $2,000,000 and put it in ABC, LP.
โ
Partner A puts in $100,000.
Partner B puts in $100,000.
Partner C puts in $100,000.
The rest of the cost ($1,700,000) is bought with debt. No one guarantees the debt, as it's stabilized and a profitable rental.
โ
Year 1, accelerated depreciation is taken and they deduct $600,000 in depreciation.
โ
On their tax return, each partner will be able to deduct $200,000 of rental losses even though they only contributed $100,000 and not be limited due to "at-risk" basis.
โ
Even though the debt is nonrecourse, because it's qualified nonrecourse it's considered "at-risk" for them.
โ
And the partners are technically not in a negative capital account because of the "minimum gain" they would recognize if the asset was disposed of for it's book value.
โ
Some caveats - the partners would still need to overcome ยง469, or consider a ยง469 aggregation election assuming real estate professional status. But again, beyond this week's scope. You would also need good Operating Agreement language for minimum gain and chargeback terms.
โ If this confused you, thank you for at least scrolling down to the bottom. ๐ค This confuses a lot of CPAs and tax professionals as well - not to mention attorneys who have to consider this when drawing up agreements. The best takeaway is that not all debt is created equal - and the tax code is slanted towards real estate. ๐ทโโ๏ธ ๐ซก ๐ Reminder that I offer one-off paid consultations. Reply to this email to set up a call. ๐
โ ๐จ๐จHave a Question - send a reply directly to this email and I'll answer it in upcoming emails ๐จ๐จ Have an idea for a newsletter? Would love to hear from you. Want a deeper dive on anything above? Let me know! Want to read previous issues? Click here.โ If you enjoyed this, please forward on to a friend and let me know on X / Twitter. |
The Plug [Newsletter]
I've been a CPA for nearly 20 years - serving private small business and real estate the entire time. I take the lessons learned in serving and now running a small business and share them here. For business owners, investors, and advisors looking to lower their cost of capital, subscribe for delivery straight to your inbox ๐ Also on YouTube at PlugAccountingandTax!
A powerful unlock ๐ in small business is owning your own real estate. It protects you from rent increases and inflation ๐ It accretes to your balance sheet the value of a reliable tenant (yourself) ๐ค It opens up additional and creative ways to finance business operations with tax benefits ๐ค But that last point isn't a slam dunk. Section 469, the passive activity loss rule from 1986, treats all rental real estate as a passive activity by default. Any depreciation losses from that real estate...
Selling a property or business can be one of the happiest days an owner experiences. ๐ But it's not until the K1s are filed and the gain is reported to the IRS that the celebrations should really begin. Every year I see a few of the same mistakes made on returns - many from other tax preparers, but some come from my own team that we have to send back through QC. These can shave off percentage points of IRR. ๐งฎ Today, we're talking about some of the biggest errors I see in the year of a sale of...
If you can get past the absurdity of the name ๐, the new Trump Accounts are worth looking into for those in the gifting stage of life. While this newsletter is geared towards small business and real estate, reducing tax burn to the ultimate taxpayer is the end game - and since this new gifting ๐ account has a business component, it's fair game. So let's talk Trump Accounts ๐คฆ We'll cover a few pieces of it: What they are How most people will use them How business owners can use them What are...