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Tax Smart Real Estate Investors Podcast
MLRE: Disguised Sales: How Refinances Can Trigger Unexpected Taxes in Syndications
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In this episode of the Major League Real Estate P…
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- [00:05]
A
Welcome to the Major League Real Estate Podcast, a podcast for operators of large scale real estate portfolios. My name is Nathan Sosa and I'm your host. Together with my co host, Matt Hamilton, we talk about tax and legal strategies and we bring on operators large portfolios for in depth discussions on how they grow their business. We hope you enjoy. Hey everyone, welcome to another episode of the Major League Real Estate Podcast. I'm joined by my co host, Tom today. And today we're going to dive into what happens in a situation where, hey, maybe GP contributes property and then, you know, they want distributions back. But there can be a lot of rules and a lot of nuances that could trigger actually a sale event on that contribution. Right. So we'll dive into that in just one second. But first off, got to do the weather check with Tom in Miami. How are things going, Tom?
- [00:51]
B
Oh, it's been beautiful weather recently. It's 82 degrees right now, just out in south beach yesterday with my aunt, my uncle, they came through from New York and we went to Southeast, got a little sunburn. It's kind of already faded away, but that was definitely very fun. It's going to get a little cooler here this week back into like the low 70s and like high 60s. I think that's going to be due to what I'm seeing is that every time it's cold in the Northeast, it ends up making its way down to South Florida. So that's the weather check. How about you, Tom?
- [01:20]
A
It So it was 70, it was 85 degrees on Friday and now it is 30 degrees today. We literally had 50 mile per hour winds yesterday that blew in this lovely cold front and basically knocked out power in like half of Oklahoma. So that was super fun. 50 mile per hour gusts, all kinds of fun stuff. Literally had to run a generator out to my wedding venue because we lost power in the middle of a wedding. So not a fun situation to deal with. But everything's all good, all kosher couple got married. So all we can say there.
- [01:51]
B
All right, that's a wild swing. That's a wild swing in temperature, I have to say.
- [01:54]
A
But it is indeed, man.
- [01:56]
B
But it seems like today, the topic of today's episode is going to be around disguise sales and whether or not cash out refinances or distributions back to partners who are contributing property to a partnership, for example, contributing a multifamily property into the partnership, whether or not that's a disguise sale. And you know, we talk a lot about how cash out refinances and lines of credit and loan proceeds are not taxable. And that's generally true, especially if you have a property you own directly. But it seems like when we get into the partnership tax law, there are some more complicated rules that you have to be aware of and to navigate.
- [02:32]
A
Yeah, Tom, it's actually like there's a lot of nuance. The more you dive into this, the more you realize it's not necessarily like a. Oh, yeah, no problem. Right. I get a distribution, it's tax free. Right. I know we talked about that all the time. Is that like, hey, you did this research, they're kept tax free. You're only taxed on what shows on your K1 right in that box. One corner. Right. But it's actually kind of nuanced. There's a lot of, like, things we got to look through on that especially. Right. Once you start getting into contributions of property and then distributions of cash going back. So there's a lot of nuance we got to consider there. So with that being said, Tom, I think we should at least look at and like maybe talk about distribution basics first. Right. I think we should like, at least kind of dive into that. So, Tom, like, typically, I think I kind of gave a lead away, but like how distribution is normally dealt with in a partnership. Right. How does this normally go?
- [03:18]
B
Yeah. So typically what's going to happen is we talked about this on a recent episode here on the MLRE podcast, but you're going to have your basis in the partnership. Your basis typically is your contributions to the partnership. So for example, you contributed $50,000 cash. You're going to have a basis of $50,000. Right. Also, income allocations and gain allocations from like example, you have net income or you have a capital gain that also can increase your basis. Right. That's going to increase your basis. And then distributions are going to typically decrease your basis. Losses, including losses generated by depreciation, which is very common here in the real estate space, also decrease your basis. Right. So that's just kind of a high level crash course. Right. We're dealing with your basis and distributions, again, typically decrease your basis.
- [04:10]
A
Yep. And, and with that, between, said, Tom, is that when debt gets paid off or paid down or transferred to another partner too, which is FYI, that also is a deemed distribution. So just FYI on that, people forget about that a lot. It can be forgotten during tax planning time too. I've seen that where it's like, hey, cool, I got this projected liability. It's like, oh, great. Did you factor into the fact that they're also getting those liabilities distributed. Everyone goes, oh, no, I didn't think about that. So let's say there's $500,000 of debt in the partnership. It gets paid down to 50 by the partnership. Well, you, you just got relieved of $200,000 of debt. Right. So it's kind of the deemed distribution against that can happen liquidations as well. Yeah.
- [04:46]
B
So it's kind of give an example of what that would look like. Maybe say, for example, I had a liability I transferred to the partnership, a partnership tax alone that I basically the partnership took over. Right. And they pay it down, like you said, $500,000, but they pay it down 250 because the partnership paid down the loan. I am now receiving a deemed distribution. Is that correct?
- [05:07]
A
Right. 100%. Yeah, you're totally right, Tom. That's exactly correct. Okay.
- [05:10]
B
Okay. So there is a level of complication when you do get into the partnership law here. So I know that sometimes syndicators face this issue. So why don't we break down a scenario of where syndicator might run into this type of issue?
- [05:25]
A
Yeah, Tom, so I'll preface this like so731. That's typically how we're going to run into this. But let's think about. So let's say we have a contribution coming from a GP and they are contributing a 200 unit property. Right. Let's just say that's a doing it. They're getting this thing off and running and they want to use some of their own portfolio to make this happen. Right. Rare scenario, but could happen. So they're going to plug this in and then you're going to plug in 200 unit deal. Right. Do value add, then potentially look at refinancing later and sending checks to the LPs. Right. That's what. So let's say they do all of that time. Now that actually can create a disguise sale trap, actually. And so, Tom, there's a chance that can be called a disguise sale, actually. And disguise sales, that's not typically what investors are or GPs are wanting to look for out of the first few years of their deal.
- [06:11]
B
Yeah. Disguise sales are usually unintended or at least something you want to avoid, be aware of. That could happen because disguise sales usually happen when you didn't actually sell the property, but you, you transferred, you effectively got around it. If that so basically happens is like you didn't sell the property and get a gain. Instead you transfer the property to the partnership, for example, and then the partnership went and gave you a distribution as if it's almost equating to the fact you did sell, right? So as if I gave a partnership $500,000 property and then I got a distribution of 400k. That might fall under the disguise sales situation.
- [06:47]
A
Real estate syndication tax is confusing to you. What? Well, that's why hopefully you listen to the podcast today. Also you should go to our website, www.the realestatecpa.com and you'll be able to get access to the ultimate guide to Real Estate Syndicators and Sponsors, which breaks down everything from preferred returns, depreciation strategies. Whether you're a GP or an lp, avoid costing mistakes and maximize your returns. Download the complete guide free and get the taxpayer you need to succeed. No, a hundred percent, Tom. Right? It's like, it's like, it's everyone's like, oh, I can subvert tax code, right? It's like I can avoid this by going this way, right? Like it's a play everyone like, think about. But hey, these rules exist for a reason, right? And like they've existed for a long time, actually, because people have tried to do this for a long period of time. And so. Okay, let's run through that situation, Tom. So effectively, let's say the GP or contributing partner, right? Because a lot of times you can have a large LP that wants to give the property. So it doesn't just be the gp, it can be a large contributing property. So they drop in a pretty large piece of property, right? Like that 200 units that I mentioned a second ago. So they drop in 200 units, no problem. Now the GP runs the value add side, right? So now they're running value add, they're improving the property. They're making this like they are double. Let's even say they're doubling the basis, right? Maybe it's a qoz, maybe it's in a qoz. That will get really complicated. So it won't go there. But let's just say they're doubling the basis of everything they put into it. Awesome. Fantastic. Now they look at the property and they go, wow, this value's been doubled since of the cash that we put into this. It's fantastic. Let's refinance. And now we can pay everybody back, right? Now we pay everybody back. And so everyone's getting the distribution, including that part, the original partner. And sometimes due to the rules of 704B, a lot of distributions might have to flow to the contributing partner. Well, that can create an issue, Tom. Right. So like it's been after two years and so now we've got a two year time span and now they're getting cash back and it's being distribute to the person that put the cash in. Right, right. Sale, doesn't it Tom?
- [08:44]
B
Yeah, yeah, it sounds like it on the service because it's like you, you effectively got the results of a sale without actually selling it and incurring the capital gains taxes. That's kind of the entire premise here of what we're talking about here. This guy's sale is it's disguised, it's not a sale, but it kind of dressed up as one.
- [09:01]
A
Right? That's the scary part because all of a sudden you go hold on, hold on, hold on. I didn't want to do a sale. That wasn't my intention here, wasn't my plan. So I don't want to get that treatment. Well, there actually is a debt finance distribution safe harbor that exists, right. Because they want people to be able to do this type of thing. And so what that, so what does that mean? So you run into this exact situation where you contribute the property and as long as there's an allocable qualified liability, that means it's not going to be viewed as a disguised sale. Right? So that means if you have a contribution, they refinance, takes a loan up to 3 million. The first 2 million distributions that are alcohol GP are fine, right? That's allowed, right. The extra 1 million of debt though, that's where it could get tricky right now you might need to be, you might be able to allocate it to other partnership debt. But got to ask the question, is it a qualified liability? Right. Is it associated with the property? That's the question we have to start asking to ensure that this guy sale treatment is going to be avoided and not actually create a gain for this contributing partner. So Tom, mechanically how does that work? Right. So we talked about distributions and outside basis, right? And now it's is really confusing because people are like trying to line up their capital account and then it's their basis all at the same time. So I guess mechanically, how does all of this work? What does that mean for them? Are they going to get additional capital gains? What's going to happen?
- [10:17]
B
Yeah, so basically what happens is this is all covered under section 707A to cap B. And basically the IRS treats the distribution to the partner, usually the general partner or contributing partner, as a disguised sale rather than just a regular partnership distribution, which is usually what they want.
- [10:34]
A
Want, right.
- [10:34]
B
They usually want just to be a Regular partnership distribution. So if a partner contributes the property and receives a distribution within two years, there is a presumption of sale here, right? And to give an example, let's say a general partner, right, contributes a property worth $2 million. It's the fair market value of the property. So if they went and sold it today, they would reasonably be able to get $2 million for it on the open market. And that that Property is a 500k basis. So they more or less bought the property with or perhaps after taking depreciation. That's their basis, 500K. And now the partnership, they absorb it into the partnership. The partnership refinances that property and sends 1.5 million back to the general partner within 18 months. Again, we're looking at this two year window here that looks like a sale of the property and the GPA may owe tax on $1 million of gain. And again, it's because think about what the general partner is doing here. They could have sold the property for 2 million. Instead they're contributing to the partnership and then getting a distribution back to them that's substantial within a very short period of time. It almost looks like a disguise sale.
- [11:33]
A
Exactly, Tom, you're right. You're totally right. And like that's where that qualified liability is super key, right? It's a defined term. It's a qualified liability is basically a liability that's on either the property for it's contributed or liability. The contributing partner was then allocated under 72 for at least two years. Right? So that's what's really important here is that like once you contribute a property, you gotta be careful with distributions for at least two years before you start taking distributions. Right? So that's something that's like super, super important to consider and look at and it falls into that qualified and allocable process. Right. If it doesn't fall into that bucket, you kind of like that. So also premise that too, that's a safe harbor. Safe harbor is basically like the IRS says, hey, we won't go touch that zone. We don't consider that gray. If you fall into that safe harbor, we're not going to argue it, we're just going to put our hands up and say it's a safe harbor, it's safe, we'll leave it alone. If you fall out of it, it doesn't mean you can't still argue with the irs. It just means that now they can actually come after it. Right? That's why safe harbors are easier. Let's just live with it. Safe. Safe harbors are easier. The IRS has nothing to combat. They can't come at us. Right. We see this all the time with profits, interest, with Reprop 93 27. Right, all that, all those things, right? Like when it comes to profits interest. Profits interest, units. But same thing here. We want to live in the safe harbor if we can. Doesn't always happen, unfortunately. Sometimes we play a little bit in the gray here in partnership, taxable world, but totally impossible for us to make sure that we don't hit this. Right? We just got to make sure if we can structure it to be in the safe harbor, that'd probably be better, right, Tom?
- [12:58]
B
Yeah, I mean, if you could structure it within the safe harbor, that. That's ideal, isn't? I mean, because then you don't have to worry about this. And that's. This is something that your typical, you know, entity structuring syndication attorney is probably not going to be able to assist you with. You're going to need to bring in someone on the tax side to help you navigate these rules. Am I, Am I off base there, Nate?
- [13:15]
A
No, you're totally on point, Tommy. That's something that, like, maybe the syndication attorney's aware of it. They've kind of seen it before, but that's not their world and their expertise, right? That's where you need to work as a tax advisor to pull them in to have conversations about that. Right? That's like, so without you, hey, you find out that, like, hey, you're going to be okay under debt finance, but hey, FYI, we might have to fight this with the irs. So let's start building our position now so that we are well protected later down the road. Right? Like, I understand, like, it feels kind of weird, confusing, but these things are laid out in the tax code and like, we have to follow that or we should follow them, or at least if we're going to be in the gray, we. We document why we did what we did at that point in time.
- [13:51]
B
All right, Nate, so let's. Let's go ahead and see where the rubber meets the road here with some practical situations that we often find general partners, sponsors finding themselves in as it relates to these rules.
- [14:01]
A
Yeah, Tom, So number one, like where the GP contributes to property, right? GP contributes. Property partnership immediately distributes the acquisition loan proceeds back to the GP as a return of capital or the contributing partner, right? Like ignore, like the label that I'm giving. That's a really, really common disguise sale fact pattern, right? Unless the trading partner or GP was personally liable on that debt before contribution. And now that partnership level debt is effectively funding a distribution back to the GP within two years, they're going to look at the arsenal. Look at that very closely. Right? So that's one pitfall that we see happen a lot, right? It makes sense, right? You want to give them back and say, hey, you give me the debt, I'll return this back to you. Totally makes sense. I get it. But it's something, it's a fact pattern we really have to think about. And then the next pitfall that we sometimes see is disproportionate distributions. Right? That is where the partnership refinance and distributes the cash, but the contributing partner, I mentioned this earlier, gets more fair share of the ownership percentage than they should. Right? That's actually going to, again, going to be looked at by the irs. A lot of these are pitfalls. We're saying these are ones that are falling outside that safe harbor. Again, I just want to say. I just want to emphasize that these are just situations that potentially fall outside the safe harbor. So those are the first two that we generally see. And this is the third one. This one we just ignore the rules entirely and we just say, hey, I'm going to put in the property and then this person's going to get a distribution of equal value for market value back. Right? I can't really do anything about that. There's nothing we can really do there. Because I'm just saying, hey, we can try to build our case in the event of an IRS on it, but it's going to be a little tricky for us to do that. So just an FYI on there is that like, hey, these can happen and they need to be built in on the front end, right? When you have. When you have someone that's wanting to contribute properly on the front end, you should probably talk to a technical tax advisor and say, hey, I've got someone right now who's wanting to put property into my syndication. How does it work? Can I do that? Does it make sense for me to do that and then actually go through the steps and kind of lay that out in your operating agreement?
- [15:52]
B
Yeah, yeah. Definitely want to get ahead of this and structure it the right way to avoid these situations from becoming a disguise sale.
- [15:58]
A
Right, Tom.
- [15:59]
B
So, Nate, what should syndicators do if they're thinking they might be subject to these rules or something like this potential transaction like this might be coming up for them?
- [16:08]
A
Yeah, Tom, step zero, start working with a tax advisor. Right? So that's the. With a syndication Focused tax advisor. Right. That's step zero. But actual step one, track outside basis, year over year, your cpa, that's why I said step zero because they're going to help you do that and they're going to make sure that you're okay with that. Let you know if someone's going to get hit with some capital gains somewhere between now and then. Right. So they'll focus on that. Number two, if someone is contributing a large piece of property to the syndication. Right. I think it's worth having conversation about timing and source of cash and. Absolutely. Because we want to ensure that this is not going to be a taxable transaction. So that's number two. Number three, build that two year window into the operating agreement and the capex planning. Right. Got to build that fact in. So hey, that way we fall under that debt finance provision. That way if the IRS ever sees that or say, hey, here's two years, we didn't do any cash distributions, double thumbs up, right. So that way the IRS can't fight us on that. And then number four, right before the refinance happens. Right. Like going inside four and zero, kind of the same loop in your attorney and tax advisor. Right. You should, you got to have a bench build a bench that is going to support you as you go through all these steps together. Because it's super important that you have people you can rely on and start building that out. Right. I've seen a lot of syndicators who start, who build half their bench and then get rolling. Right. And I'm not saying you can't build it as you go, but the more qualified people you have on your team, the better off you're going to be and the better off you and your LP is going to be and the better return on your investment you're going to create. And then of course, documentation, that's where after you loop in your attorney and cpa, they're going to help you build the documentation so that if we fall into a gray area at the irs, we can still combat it at the end of the day.
- [17:44]
B
Yeah, absolutely. So basically what I'm hearing is have the right expertise on your team and do things proactively and then document your position, which is a major part of planning for any major opportunities. A lot of times these things don't just spring up out of nowhere. Usually you're going to plan to do a refinance at some point if you are going to do a refinance. So it's not like this is just, oh, today we decided to do a refinance and that's rush. So there's a lot of things you can do proactively to put yourself in the right place. And you know, I talk to a lot of syndicators who are looking for a new CPA and oftentimes they've outgrown their cpa. They don't have these level of expertise and then they end up having to scramble when things do come down to the wire. Or their CPA is like, oh, hey, wait a second, you might be subject to this, but I can't help you, right? So like, if you're going to be in the game of syndication and I might, this, this might be preaching to the choir for some people tuning in here. But if you're going to be in the game of real estate syndication, if you're going to be in the game of real estate funds and you're going to be raising capital from outside investors, you have a responsibility. You are steward of other people's capital and they're relying on you to make decisions not only so that the investment goes right, of course, that's primarily why they're investing with you, but also that you have the tax aspects and things buttoned up. So if something like this does come to light that you're able to fully inform them of how things are going to go on or whatever the case may be. So if you are interested in working with a CPA firm that does specialize in syndication and fund related matters or private equity related matters and partnership related issues, then I invite you to schedule a discovery call. You can use the link here in the show notes to this episode to book a call. We're happy to learn more about your situation, what your current plans are, what your future plans are, and see how we might be able to help fit into the equation and be that CPA or be that tax advisor that you need on your bench to help you navigate situations like this. Because frankly, this is stuff that we see all the time. Nate sees this stuff all the time. Our private equity team here at whole CPA sees this type of stuff on a regular basis. And as long as we have enough time to see it coming, we can help you navigate these situations and put yourself in the best position for not only you as a general partner, but also for your limited partners as well. And of course, we want our limited partners typically to reinvest with us and just make sure we have everything all buttoned up. So again, link it to Discovery call is in the show notes to this episode. That's all I have for right now. Nate, any closing words?
- [20:07]
A
No. Tom, like you said, is that, like, get ahead of these situations before they happen, right? Because, like, look, it's hard to put anybody in a rush and say, hey, I need this in the next, like three, like two, two weeks. Right? Like, so, like, that's why just being proactive, reaching out to us beforehand, thinking, hey, we can get it. We can help you get ahead of it and we can act fast. Just let's work together on that. So that's all I've got today. Tom, thanks so much for coming on today. And this has been another episode of the Major League Real Estate Podcast. Thanks for listening to the Major League Real Estate Podcast. There are three ways you can connect with us. If you're interested in getting email updates on upcoming shows, go to www.therealestatecpa.com and subscribe there. If you'd like to explore a tax and accounting relationship with our CPA firm, you can go to www.therealestatecpa.com mlre and fill out a web form to get started. And if you'd like to connect with Matt or I on social media, you can find us on LinkedIn or Twitter. Just search Nathan Sosa, CPA Matt Hamilton, CPA and shoot us a request. We'd love to connect. See you guys next time.