Real Estate Advisor - October, 2017

October 17, 2017

Centralized Partnership Audit Rules Take Effect in 2018

By Alan M. Blecher, JD, Partner, Real Estate Services Group

When the Bipartisan Budget Act of 2015 (BBA) was enacted, the 2018 tax year seemed relatively far away. Now that it’s at our doorstep, it’s time to revisit the act’s new centralized partnership audit regime rules, which will apply to the filing of partnership tax returns for tax years beginning after December 31, 2017.

This past June, the IRS issued 69 pages of proposed regulations to implement this new regime. In general, the overarching theme is that any IRS adjustment due to a partnership level audit will be assessed and collected at the partnership level. Under the current TEFRA rules, the resultant adjustments flow through to the partners from whom the tax is collected.

If the IRS determines that adjustments are required for the partnership tax year (“reviewed year”), the partnership is required to pay an “imputed underpayment” with respect to the adjustment in the year in which the adjustment is finalized (“adjustment year”). The new audit and adjustment rules apply to all partnerships, except for certain qualifying partnerships that affirmatively elect out of the new rules for that particular tax year.

Procedures for Electing Out

Certain partnerships that issue 100 or fewer Schedules K-1 may elect out of the new regime, provided that each partner is an individual, a C corporation, a foreign entity treated as a C corporation, an S corporation, or the estate of a deceased partner. (Note: Each shareholder of the S corporation is included in the count to determine if the 100 or fewer Schedules K-1 threshold is met). If a partnership has one partner that is another partnership, a trust, a disregarded entity, or a nominee, the partnership is ineligible to elect out. A partner that is a tax-exempt entity does not thwart the ability to elect out, however.

The proposed regulations stipulate that the election out must be made annually on a partnership’s timely filed return, including extensions.

The IRS has made it clear that it will severely limit the ability of partnerships to elect out. The Preamble to the proposed regulations states that for partnerships that elect out, the IRS will be required to open audits at the partner level to adjust items associated with the partnership, resolve issues, and assess and collect any tax that may result from the adjustments. Each partner-level proceeding is subject to its own statute of limitations and venue, which often results in separate partner-by-partner determinations regarding the same item. This explains the IRS’s institutional bias against electing out.

Elections out will be subject to strict scrutiny from the IRS, focusing on whether the partnership has accurately identified all of its partners and whether two or more partnerships that have elected out should be reconstituted as a partnership ineligible to elect out, under existing case law and general federal tax principles. The new rules and heightened scrutiny are sure to increase the number of partnership audits for both partnerships that are subject to the new centralized partnership audit regime and partnerships that have successfully elected out.

Push-out Elections

An incongruity in the new regime is that the imputed underpayment is paid in the adjustment year, and thus may affect partners who were not even in the partnership in the reviewed year. However, a partnership may elect – no longer than 45 days after the date of the notice of final partnership adjustment – to pass the adjustment through to its reviewed year partners. Under the proposed regulations, the period for making this election may not be extended.

“Push out statements” must be filed and provided to the partners within 60 days of the final determination of the partnership’s tax liability. Detailed rules are included on the statements to help partners determine their additional tax due.

As of now, the proposed regulations “reserve” the issue of whether a partner which is itself a pass through entity could elect to push out the adjustment to its partners. The IRS is considering allowing such a push out, and proposed regulations addressing that issue are expected “in the near future.”

Partnership Representative

Under current TEFRA rules, a partnership designates a Tax Matters Partner (TMP) to act in the event of an audit. Under the new regime, partnerships must designate a “partnership representative” who, unlike a TMP, does not necessarily have to be a partner, but must be a person with a “substantial presence” in the U.S. The proposed regulations stipulate that a partnership must designate the partnership representative for each year on the partnership’s return filed for that year. A designation for one tax year is not effective for any other tax year.

The proposed regulations also provide that any action taken by the partnership representative binds the partnership and partners for federal income tax purposes, regardless of any other provisions of state law or the partnership agreement. Only the partnership representative can act on behalf of the partnership in agreeing to settlements, agreeing to a notice of final partnership adjustment, making the push-out election, and agreeing to extend the statute of limitations.

Action Steps

Existing partnerships should revisit their agreements in light of the impending changes, and partnerships just getting off the ground should likewise heed these new rules. Issues such as whether to elect out or push out should be addressed.

The crucial role to be played by the partnership representative should also be considered, both in determining whom it should be and in placing restrictions on his or her ability to act without consent. Acts violating the agreement will still bind the partnership with the IRS, but the partnership will have recourse against the partnership representative through the partnership agreement.

Sustainability in Affordable Housing: The Economic Benefits of Investing in Community

By Joseph M. Klein, CFE, CPA, HCCP, Partner, Real Estate Services Group

Many modern real estate investors are looking for more than a wise investment and handsome return. They are also aiming to make sustainable investments in projects that will have a far-reaching impact on the community and surrounding landscape. They seek to develop or redevelop real estate where sustainability’s impact on economic growth can be felt acutely.

“Sustainability” encompasses a broad range of elements, from smart energy usage and responsible environmental awareness, to social diversity and economic development. Sustainable building is particularly rewarding in affordable housing localities that encourage or incentivize such practices.

In broad terms, “affordable housing” encompasses new construction or rehabilitation developed at levels affordable to low- and moderate-income households. Most of the related incentive programs (e.g., the Low-Income Housing Tax Credit program, down payment assistance programs, community land trusts, public housing) utilize a subsidy to reduce housing costs to below-market rates and align the costs with what these households can afford.

The benefits of affordable housing are not limited to the occupants – who receive a modest but safe place to live – and the governmental municipalities that reap the fiscal benefits. When the construction complies with sustainable housing practices, affordable housing can help the community at large. It can stimulate local development and foster widespread economic growth.

Job Creation

As with market-rate housing, research consistently shows that developing affordable housing creates jobs. This remains true both during the construction phase and beyond, as new residents turn into new consumers and start spending money. In fact, the impact of developing certain types of affordable rental housing is on par with the impact of comparable market-rate units.

Energy Efficiency

While the environmental benefits of energy-efficient practices are reason enough to pursue sustainable projects, these same housing practices can also provide significant economic opportunities for affordable housing communities.

Various energy rating systems that are becoming increasingly popular in new home construction include standards that promote the use of local products. Theoretically, “buying local” allows builders – and ultimately consumers – to reduce the embedded transportation energy usage associated with construction. Using materials produced by regional suppliers could also translate into more jobs and higher capture rates of the indirect spending associated with new housing construction.

Economic Growth

Contrary to the common belief that affordable housing drives property values down, studies show that the projects actually have a positive effect on property values. Factors such as the type of subsidy program, the stability of the neighborhood, the size of the development, and what the new construction replaced (e.g. a vacant lot) can all help to predict how new affordable housing will influence property values. The strength of the overall economic market in which the project is situated is another major factor in how successful these efforts can be at spurring local economic growth.

For example, consider the substantial rehabilitation of more than 35,000 units that New York City invested in during the 1990s. In turn, the city raised millions in additional property tax revenue over the ensuing 20 years, which more than made up for the city’s outlay into the program’s subsidies.

Lingering Effects of Sustainability

In addition to the direct effects of local consumer activity, employment opportunities and rising property values, the development of sustainable affordable housing has the potential to create indirect effects that ripple out to the entire community,

During the construction phase of affordable housing, the local economy reaps obvious direct benefits from the funds spent on materials, labor, etc. And if the builder purchases sheetrock and windows from a local supplier, the supplier may have to spend money on replacement materials and hire additional help to complete the order – examples of indirect effects. These benefits are compounded by the construction workers, welders and landscapers who are spending a portion of their wages at the local grocery store or shopping mall – examples of induced effects.

Even after construction has completed, the availability of affordable housing gives employers – and even regional economies – a competitive advantage because of their ability to attract and retain workers.

When revenues generated from occupants of affordable housing exceed the costs of providing services, everyone wins. The fiscal benefits continue to flow back to the community at large, the investors are happy with their returns and societal contribution, and the investment has lasting positive effects on residents’ residual income.

Is it any surprise that affordable housing is considered a sound and sustainable investment choice these days?

New Co-Working and Co-Living Trends Emerge as Profitable Real Estate Opportunities

By Erin Kiernan, CPA, Senior Manager, Real Estate Services Group

As the number of millennials continues to surpass Baby Boomers - in both overall population and the workforce – it is increasingly important for real estate owners and developers to pay attention to evolving trends in their living and working preferences. This generation is no longer only teenagers and college students, but rather market influencers with the power to demand and expect certain experiences, work spaces, social environments and conveniences.

Co-working spaces in the New York City area have risen in popularity since their arrival in the city in 1999. These shared space provides entrepreneurs, telecommuters, startups and freelancers an alternative to working from home or office. Co-working also allows occupants the benefits of greater productivity, sense of community, and networking opportunities that they may or may not experience by working from home or in their own office.

Most co-working spaces include the conveniences of wifi, kitchens, conference rooms, private offices, communal spaces, outdoor areas and ready access to business tools.

Corporate Co-working Trend

Major corporations around the globe are jumping on the co-working bandwagon by providing access to these spaces for their remote employees, creative staff, freelancers, independent contractors and other collaborative teams. These companies recognize the power of flexibility, creativity, community and work-life balance that these spaces offer this new generation of workers.

The benefits are not only realized by the workers, however. Corporations can benefit from cost-savings, increased productivity and greater engagement from their remote workers. Co-working spaces also foster innovation among workers, aid in recruitment and retention efforts, and provide a more economical use of the space as office utilization rates continue to decline.

NYC startup WeWork reports that, of the 500 most valuable companies in the world, more than 10 percent of them had workers in the company’s co-working spaces at the end of 2016 – up from less than one percent just a year prior.¹ This number is sure to grow as technological advances continue to make remote working even more beneficial to a company’s bottom line.

Co-living Trend

A new trend is also emerging in the housing market that mirrors many of these amenities and benefits in an effort to attract millennials who value both camaraderie and convenience in their personal lives as well. Co-living is a developing concept in which residents typically have their own bedrooms – and sometimes bathrooms – but share the rest of their living spaces with other residents. While more common in California, co-living spaces have started to spring up in Manhattan, Brooklyn and Jersey City.

This “social living” model is gaining in popularity as this new generation of professionals continues to delay homeownership. In true millennial fashion, co-living inhabitants are expressing their preference for experiences over material possessions and their affinity for enhanced amenities all under one roof. In additional to fully furnished kitchens and professional cleaning services included in the rent, these buildings usually include gyms, laundry facilities and outdoor spaces.

Co-living typically allows for lower price points for the younger generation of renters as well, although some studio locations offered by WeWork in New York City are actually bringing in higher median rental rates than their traditional studio apartment counterparts.²

Profitable Prospects

These new concepts in working and living are here to stay and provide substantial opportunities and advantages for real estate professionals, especially as they grapple with the challenge of repurposing old properties for more modern utilization.

Corporate co-working, for instance, will bolster the sustainability of co-working spaces as it provides more stable clients and long-term commitments. Interest from corporate giants is growing rapidly, making the development of co-working spaces more viable and attractive than ever.

The co-living trend is already beginning to attract major landlords, developers and investors in New York City as they realize its true profitability potential. In addition to the more economic use of space, co-living spaces also require fewer installations of kitchens, bathrooms and other rooms that are shared in this new living arrangement.

As the lines between home and work continue to blur, some co-working spaces are even being developed within traditional residential buildings, as an amenity to attract those looking for better work-life integration. Residents can combine the benefits of co-working with the conveniences of home for just one monthly rent check, while landlords, developers and investors can reap the rewards of their building’s competitive advantage.

¹https://www.bloomberg.com/news/articles/2016-11-04/big-companies-start-buying-into-wework-offices

² http://www.businessinsider.com/what-is-co-living-2017-2

Exercise caution with joint venture financing

With the real estate market on the rise in many parts of the country, developers may have more opportunities to obtain financing through joint ventures. Such arrangements can certainly pay off, but developers must take precautions before jumping in. Here is a look at several issues to address early on.

Economic issues

Since the goal of both parties in a joint venture is to turn a profit, the following economic issues are critical to address before entering into an agreement:

• What is the equity investor’s preferred return on investment?
• Will the developer earn the same preferred return?
• Will both parties’ equity be treated with the same priority?
• Will the developer’s preformation costs and contributions count as capital contributions?
• After the preferred returns are paid out, will the developer receive a “promote” or “carried interest” incentive?

A joint venture also raises several tax issues that parties should address in the agreement. This includes income allocation, depreciation allocation and lockout periods on the property’s sale and debt repayment.

Decision-making authority

Minimize disputes by delineating the decision-making authority clearly. Experienced developers know that a project can grind to a halt if an equity investor insists on control over relatively minor decisions like leases and repairs. The parties must find a happy medium that does not risk a delay in operations but still allows investors to protect their interests.

Typically, the developer will oversee construction and day-to-day operations of a completed project via an affiliated management company. But the investor will have a vote or veto rights on major decisions, such as the admission of new members to the venture, reinvestment of proceeds, financing, budgets, and property purchases and sales.

Construction cost overruns

During construction, the construction loan guarantee will require the developer to fund overruns. The joint venture should establish how to treat such payments.

Options include requiring the developer to simply absorb the costs, treating the costs as capital or as loans. If the agreement treats the payments as capital, the return on such capital is generally subordinate to the equity investor’s preferred return.

Exit strategies

All good things must come to an end, as the saying goes — and that applies to financing joint ventures, too. It may be counterintuitive to think about how the partners will exit the arrangement before construction has even begun, but doing so can help avoid some uncomfortable and potentially costly conflicts later. For example, the parties might disagree about how long the venture should hold onto the property after construction ends.

The joint venture agreement should provide for a clear exit mechanism that either party can use to leave the venture on a triggering event, such as the death, incapacitation or misconduct of one of the partners. These agreements usually specify a minimum hold period after project completion in order to secure capital gains treatment for sale proceeds.

After that period, the agreement should specify what happens next: The business can dissolve, or a buy-sell clause can be activated, requiring one party to purchase the other’s interest based on a valuation by a neutral appraiser. Alternatively, the agreement could allow the parties to market the property for sale to third parties. A partner who declines an offer that’s acceptable to the other partner must either buy the other partner’s interest or sell its interest to the partner for the value set by the third party’s offer.

Worth the work

Joint venture financing often works well for both parties involved. With proper planning, you can avoid potential problems, and the project can leverage the developer’s real estate expertise and the equity investor’s capital.