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 π Also on YouTube at PlugAccountingandTax!
Specially Allocating Depreciation π - How to Actually Do It
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The best attorneys are specialists - ideally at keeping you out of trouble. This specialization mostly comes in the form of transaction structuring, risk identification, or legal procedures. A few of them have taken a wrong turn and wound up as tax attorneys. But of those few, even fewer have ever filed a tax return or allocated income and loss on K1s. Which is a shame because that's an experience that is sorely needed when drawing up operating agreements. I've been reviewing operating agreements for clients and non-clients for 10 years now and I'm here to tell you it's only getting worse. I'd estimate that I see impactful changes on 95% of agreements I review. π Shameless plug - reply to this email to engage with me to get your OAs reviewed or designed properly on the front-end. π Back to the program - today I wanted to cover something I've see written up by a few attorneys, special allocation of depreciation. All the first passes I've seen won't pass an IRS audit. But there is a way to do it correctly. π Why DepreciationThe rationale is that depreciation, in real estate, represents one of the largest drivers of loss. And many (most) investors are going to be passive investors. General partners / syndicators can then use that depreciation as real estate professionals to reduce their cost of capital at no real opportunity cost to passive partners if it will be otherwise suspended as passive. π An Important NuanceHow these suspended losses get treated as disposal (exit) is important to clarify for this position - and important to disclose in any investment document (OM, PPM, deck). When suspended losses are unsuspended, they keep their ordinary nature π if they are from depreciation / operations. Meaning if in an exit year, there is substantial capital gain and suspended ordinary losses those ordinary losses are freed up against other non-passive ordinary income (W2, etc.). And the capital gain keeps it's preferred rate. This is even more important in an exit year where there is a loss of value - e.g. investors get equity wiped out. The suspended losses would get released against other ordinary income. Without these suspended losses, the losses would be a capital loss and roll forward at $3k a year until capital gains were enough to offset it. π This can have real tax impacts to investors and should be explained well before investment is accepted if the plan is to game depreciation to the sponsor. How It's Done in Year 1Assuming you're deals are good enough to offset any LP tax heartburn, there's a very specific formula to follow to do that in compliance with IRS regulations:
This aligns the economic risk of loss with tax allocations π€ - keeping the IRS at bay. But miss any of these steps, and you'll have some explaining to do to investors and the IRS alike. How It's Done Without Lower Priority Distribution in Later YearsTiming the cost segregation study is another way to run the allocation of depreciation. β° If your deal is modeled to outperform and return capital quickly (2-3 years), AND you'll still have a guarantee on the debt after stabilization then you can run a different play:
In this case, the economic risk of loss goes to the recourse debt holder since capital has been returned. This presumes tax capital of LPs is $0 after return of capital - which would push any losses from bonus depreciation to the debt guarantor. π«· The TakeawayI'm not an attorney - but I've signed enough tax returns and issued K1s to know a good agreement from a bad one. There are right ways and wrong ways to get what you're trying to get done. And more importantly, you need to understand the tax impacts to the investors who are trusting you with their capital - and the tradeoffs they are knowingly (or not) making. Want to get a review of your agreements? Reply to this email and let's get to work. π«‘ Group Chat Worthy Posts π₯π²
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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 π Also on YouTube at PlugAccountingandTax!
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