Hidden Flexibility in Nonrecourse Deductions for Real Estate Partnerships

Managing members of closely held partnerships, as well as sponsors and general partners of large real estate funds, should all consider how certain language in operating agreements impacts the allocations of profits and losses to partners. One of the partnership structure's most significant positive tax attributes is the flexibility afforded partners, including how to structure the economics of business arrangements. Such flexibility is also one of its most considerable negative tax attributes due to the complexity and nuances involved in partnership administration and tax compliance. 

Real estate partnerships, whether closely held friends and family partnerships, joint ventures, or large real estate funds, are all impacted by the complex income and loss allocations required when operating under the partnership tax construct. 

One such partnership concept relates to nonrecourse deductions, which are generally driven by depreciation. Awareness and consideration of how operating agreement language relating to such deductions drives allocations between partners will allow managers and general partners to have the required background needed to structure appropriate partnership arrangements suitable for themselves and their investors. 

Targeted Capital Allocations 

Many joint ventures and real estate partnerships provide for an allocation of profits and losses following a targeted capital account approach. This methodology states that net income and net losses for the year are allocated such that the resulting year-end capital account of each partner is as nearly as possible equal to the distributions that would be made to such partner under the partnership agreement in a hypothetical liquidation of the entity if all the assets were disposed of at book value. In computing allocations, an adjustment is made to each partner’s “targeted” capital for their share of “minimum gain,” which is discussed later. 

Allocations must have substantial economic effect to be respected. The partners receiving loss allocations must bear the burden of those losses. In a waterfall where equity and preferred return are returned first, or an IRR is paid first (which inherently includes both a return of capital as well as a return on capital), tax losses are generally allocated to the common (non-preferred) partners in accordance with their positive capital accounts. This result occurs because they are deemed to bear the burden of such losses since the preferred partners have priority to receive cash under the distribution waterfall. After the common partners’ capital accounts are reduced to zero, the losses are allocated to the preferred partners until their capital accounts are reduced to zero. 

Once book capital accounts are reduced to zero (for simplicity purposes, this assumes an entity only has real property and debt), members cannot technically bear the burden of further losses since they no longer have book capital. Theoretically, a lender bears any economic burden corresponding to those allocations funded by debt. This is where minimum gain is generated. 

Minimum Gain for Real Estate Partnerships  

Minimum gain is the excess of debt over the tax basis of property. For example, if members contribute $20 and use debt of $80 to purchase a property for $100, they bear the burden of the first $20 of losses (i.e., through depreciation). At this point, their tax capital would be down to zero. Additional tax depreciation of $10 would create minimum gain since the debt of $80 would exceed the basis of $70 ($100 less $30 of accumulated depreciation).  

The name minimum gain comes from the tax principle that on liquidation, $80 of debt would be relieved against $70 of basis, thereby producing $10 of gain; and as such, the minimum gain triggered on a deemed liquidation. 

Understanding Nonrecourse Deductions 

Tax regulations stipulate that the $10 of tax depreciation deductions discussed above are nonrecourse deductions. The partnership agreement must allocate these nonrecourse deductions in a manner that aligns reasonably with allocations of some other significant partnership items which have substantial economic effect and are attributable to the property securing the nonrecourse liabilities. This provision of the regulations provides flexibility to partners in how the nonrecourse deductions are allocated. 

The regulations provide an example that in a 90/10 LP/GP partnership where profits are allocated 50/50, the allocation of the nonrecourse deductions 75 percent to LP and 25 percent to GP (or in any other ratio between 90 percent to LP/10 percent to GP and 50 percent to LP/50 percent to GP) would satisfy the consistency requirement mentioned above. 

In many partnership agreements, boilerplate language states that nonrecourse deductions are allocated by ownership percentages (e.g., capital contribution ratios). However, these types of allocations can create distortions. Allocating nonrecourse deductions in other ratios (that meet the consistency test) may be more appropriate. 

Potential Distortion Created by Nonrecourse Deductions 

For example, in the real estate fund context, where limited partners contribute 95 percent of capital and a general partner contributes 5 percent, there may be a point in the fund's lifecycle where all capital and preferred return will have been returned to investors. After that, the fund will operate in the waterfall's promote tier. For example, in an 80/20 waterfall, future distributions would be distributed 76 percent to limited partners (95 percent of 80 percent) and 24 percent to the general partner (5 percent of 80 percent + 20 percent). 

Using boilerplate language where original capital ratios allocate nonrecourse deductions may create distortions in such a scenario. If the remaining properties of the fund were subject to the minimum gain rules mentioned above (i.e., where debt exceeds basis), nonrecourse deductions attributable to such properties would be allocated using original capital percentages even though all other allocations would potentially follow the 76/24 percent ratio (subject to complex computations under the hypothetical liquidation approach which are outside the scope of this article). 

If, however, the nonrecourse deduction provision of the operating agreement provided that nonrecourse deductions are allocated in proportion to each partner’s percentage of promote profits, such distortion could potentially be partially or completely alleviated. 

How to Optimize Nonrecourse Deduction Allocations 

An analysis and review of the nonrecourse deduction language in an operating agreement is appropriate for both newly contemplated partnerships and existing entities. Managers and general partners creating new partnerships and those managing existing partnerships are incentivized to understand how tax provisions will drive future allocations of tax deductions for partners. 

For existing partnerships, the tax code provides partnerships with some flexibility to make modifications to existing agreements. The tax code states that a partnership agreement includes any alterations of the partnership agreement made prior to, or at, the filing deadline of the partnership return for the taxable year (not including extensions) that are agreed to by all the partners or which are adopted in such other manner as may be provided by the partnership agreement. 

A partnership agreement must be amended before the original filing deadline of a tax return (i.e., March 15). For partnerships that have not yet generated nonrecourse deductions, this flexibility may provide managers and general partners an opportunity to analyze existing provisions and potentially make amendments in anticipation of future nonrecourse deductions. 
Any increase in deduction allocations to a partner means a corresponding decrease to another partner. Therefore, all implications of how nonrecourse deductions are allocated should be considered, keeping all partners in mind.  

Due to the complex nature of partnership tax accounting, consultation with tax advisors is recommended so that all scenarios are considered and evaluated.