FLP SURVIVES IRS CHALLENGE

Court notes transfer of real estate was for a legitimate non-tax reason Family limited partnerships (FLPs) offer a tax-efficient way to transfer assets — including real estate — to family members. Although the IRS often claims these vehicles are invalid, a recent court case, Estate of Joanne Harrison Stone (“Stone”), demonstrates that the U.S. Tax Court doesn’t always agree. Real estate transfer A married couple held about 740 acres of undeveloped woodlands. They wanted the woodlands parcels to become a family asset that the family could eventually build homes on for sale purposes. Their attorney suggested using an FLP. It would simplify the gift-giving process by not requiring the execution and recording of new deeds every year and would help guard against partition suits that could cause the land to be divided into smaller tracts. The couple formed an FLP, each receiving a 1% general partnership interest and a 49% limited partnership interest. After they transferred the woodlands parcels to the FLP, they gave portions of their limited partnership interests to their children, children’s spouses and grandchildren. They valued each 1% interest in the FLP at 1% of the value of the woodlands- the only assets in the FLP- with no discounts. After the wife died, her estate filed an estate tax return. The IRS issued a notice of deficiency contending that the value of the property she transferred to the FLP should be included in the taxable estate. Relevant law Under Internal Revenue Code (IRC) Section 2036, asset transfers made during a deceased taxpayer’s lifetime that were testamentary in nature generally must be included in the taxpayer’s taxable gross estate. There are, however, some exceptions, including one for transfers that qualify as a “bona fide sale for adequate and full consideration.” In the context of an FLP, the bona fide sale exception applies when the deceased: 1) had a legitimate and significant non-tax reason for creating the FLP, and 2) received partnership interests proportionate to the value of the property transferred. The U.S. Tax Court analyzed the two tests separately to determine whether the exception applied to the wife’s transfer in Stone. A bona fide sale Gift giving was clearly one of the motives behind the transfer, and gifting isn’t considered a sufficient non-tax reason for a transfer. The court, however, found that the wife also had another legitimate reason — the creation of a family asset — which was a sufficient non-tax motive. The IRS also argued that the transfer wasn’t a bona fide sale because the FLP partners failed to observe certain partnership formalities. For example, while they did have some documentation, such as using bills of sale to make gifts of FLP interests, the information was inadequate. Moreover, they paid FLP property taxes out of their personal funds, rather than out of the FLP’s account. (See the sidebar “Keeping up with partnership formalities” for more.) The court nonetheless determined that other factors favored a finding of a bona fide sale. Specifically, the couple didn’t depend on FLP distributions to support themselves and no commingling of personal and partnership funds occurred. Plus, the couple did transfer the woodlands parcels to the FLP and the FLP interests weren’t discounted for gift tax purposes. The court also noted that both spouses were in good health at the time of the transfer, undercutting the idea that it was testamentary. The Tax Court acknowledged that a taxpayer’s receipt of partnership interest isn’t part of a bona fide sale when an intrafamily transaction merely attempts to change the form in which the taxpayer holds property or to “recycle” value. Noting the legitimate non-tax reason for the transfer, though, the court found the transfer wasn’t an attempt to simply change the form in which the wife held the woodlands. Is an FLP for you? Properly drafted and executed, an FLP can be a valuable tool for transferring real estate and other assets. If you want to put together your own FLP, work with your financial advisor and attorney to ensure you satisfy the necessary requirements. Keeping up with partnership formalities It’s common for the IRS to charge that a family limited partnership (FLP) failed to observe “partnership formalities”. But what does that term mean? In general, an FLP will be considered to observe partnership formalities if it:

  • Operates in compliance with terms of the partnership’s operating agreement;
  • Keeps separate bank accounts (as opposed to depositing income in partner accounts or paying partners’ personal expenses with FLP funds);
  • Maintains accounting records;
  • Holds at least annual meetings with formal minutes taken;
  • Executes documents on behalf of the partnership that are in the name of the FLP and signed by the general partner;
  • Makes distributions on a pro rata basis at the same time to all partners;
  • Files partnership federal and state income tax returns;
  • Doesn’t allow commingling of partners’ personal and FLP assets;
  • Uses letterhead in the partnership’s legal name for business operations;
  • Executes agreements for all transactions, and
  • Records any real estate transfers.

HIGH CONSTRUCTION COSTS PREVAIL

Tips on how to control overall project expenses Construction costs were generally high for building materials in 2012 and the Associated General Contractors of America (AGC) is predicting a long road before costs start to stabilize. The AGC expects overall material cost increases to outpace CPI growth through 2017. So, what can you do now to keep building costs (diesel fuel, lumber, steel and so forth) on your projects under control? Get an early start While you can’t pull the plug on high building prices, there are some strategies for controlling overall project costs. First, form your construction team early, including architect, engineer, general contractor and/or a construction management firm. This will help ensure project details are hashed out and fully coordinated before you break ground. It also can minimize change orders, which add significant costs and headaches. Negotiate your change order process and fees before starting the job to ensure work done beyond the scope of the contract is well documented and approved. Familiarity with your project’s geographic area is also important. Local architects and contractors will be more likely to know what materials are in short supply and what’s produced locally and thus can be purchased at a lower delivery cost. And make sure your project team works together to order materials early to avoid expediting fees and overtime expenses. The general contractor should choose qualified subcontractors early in the process. This will allow him or her to lock in fees from the outset, potentially saving you a lot on long-term projects. Also consider scheduling projects during normally slow seasons. That’s when subcontractors are typically less busy and therefore eager to work — often at a lower pay rate. And, if you’re working on multiple projects, use this as leverage to gain better subcontracting prices. When possible, you may want to use multipurpose laborers who can serve multiple roles, which will reduce or even eliminate downtime. And evaluate whether prefabricated materials can be used to lower labor costs. Fuel costs have still been near historic highs. So keep tabs on drivers’ idle time and fuel efficiency. Schedule deliveries and pickups in a manner that reduces overall drive time. And discourage personal use of company vehicles by parking trucks at your office or warehouse overnight. One silver lining is that diesel fuel prices will likely drop a bit. The U.S. Energy Information Administration projected that the average retail price for on-highway diesel fuel would drop to $3.73 per gallon in 2013. Consider quality Use the preconstruction phase to create several budget scenarios based on a range of design options. Consider employing value engineering, which involves looking at the function of each space in the building project and then tailoring material choices to suit those uses. And don’t cut corners. If you hire the cheapest contractor or subcontractor just to cut costs, you’re putting the project in danger of cost overruns and rework. Hiring the most qualified people for your project is always the best strategy in the long run. Last, ask your attorney about adding a price protection clause in all your contracts. Keeping costs in line is key Whether you’re a small local developer or you have offices worldwide, keeping costs in line is a universal need. The strategies noted above just skim the surface on how you can keep construction costs in line. Our firm is willing and ready to help you create cost-cutting strategies that can build up your bottom line.

VALUATIONS IN A TOUGH MARKET: THINKING OUTSIDE THE BOX

Yes, the rocky commercial real estate market has taken its toll on property values. But appraisal is a prophecy of what will happen in the future. The problem now is that no one knows exactly where the market is heading or how soon it will improve. Under the market and income approaches, recent market data is used to derive current value. But scarce financing and weak performance are keeping risk-averse investors at bay. Moreover, many recent deals may have involved distressed buyers forced to sell. With few truly comparable deals for appraisers to hang their hats on, many are thinking outside the box. Problems with comparable data The sale or list price of comparable properties is the foundation of the market approach. Market data is also used to fuel net operating income projections and discount rates for the income approach. But valuators today often must dig deep to find truly comparable market data. For example, a recently sold property that appears comparable in terms of square footage, location and use might go on the market as a distressed property, resulting in a significantly lower sale price. Fair market value requires that neither the buyer nor the seller be under compulsion to act. This is not the case with many of today’s deals. You may want to ask for two numbers: 1) a normal fair market value appraisal, and 2) how much to expect if the property is sold within the next 60 to 90 days. Challenging assumptions To reach a reliable value in this market, appraisers need to normalize the data and truly understand what’s happening in the marketplace. Net operating income (NOI) may prove more important to ultimate value than past sales, particularly if you’re investing in income-producing properties. For simple, stable properties, the appraiser will probably divide projected annual NOI by a capitalization rate. But a 3-5- or 7-year discounted cash flow analysis may be appropriate for more complex deals or if NOI is expected to fluctuate as the market stabilizes. When estimating NOI, appraisers review the contracts and consider the following factors: Stability. Stabilized properties typically command higher prices than properties with high vacancy rates (except in situations where the buyer plans to repurpose the space, in which case a high vacancy rate could be a boon). A valuator should determine when the leases roll over and whether the rents are at or near market rates. Does the contract include an escalation clause? If so, has the owner collected the surplus? Appraisers sometimes find that lessors are remiss on lease details. Tenant quality. Are the long-term tenants in a strong financial position and likely to survive economic downturns? Are they benefiting from concessions made to keep or get them in the building, making it more likely they’ll bolt when the concessions are withdrawn? Free rent, furniture, office equipment and moving allowances may improve the market vacancy rate, but they hurt value by both undermining stability and cutting into NOI. To measure the effect of rent concessions, appraisers sometimes use the economic vacancy rate instead of the market vacancy rate. The former focuses on the loss of income, rather than the percentage of unrented physical space. Operating expenses. It’s important to scrutinize operating expenses and eliminate any obvious waste or extraordinary items. For instance, an appraiser might adjust NOI for above-market management fees paid to the owner’s nephew (a related-party expense). Or normalization may be needed for a gross lease in which the landlord paid an exorbitant water bill last year, due to a leak the owner recently repaired (an extraordinary item). But be aware that buyers won’t necessarily pay for operating improvements or synergies they bring to the table. An appraiser also will review the contracts to ensure that the landlord is collecting all prepaid and common area expenses owed by its tenants. Again, some may be administratively remiss, thereby lowering value. Experience counts It’s critical to ensure your valuations are built on solid ground. A qualified real estate appraiser who has been through multiple cycles knows how to compensate for the data gaps in a tough real estate market.

ASK THE ADVISOR

Are Tax Breaks Available for Energy-Efficient Construction? With the emphasis on green construction and technologies, more owners and investors are considering adding energy-efficient components into new construction, as well as retrofitting existing buildings with energy-efficient improvements. A big incentive is the potential tax benefits under Internal Revenue Code Section 179D. However, as of this writing, Section 179D tax deductions are scheduled to expire after Dec. 31, 2013 so you may want to make qualifying improvements before then to ensure you can take advantage of this tax break. Section 179D to the rescue Under Section 179D, commercial buildings, apartments (4 or more stories,for lease) and municipal buildings can take an immediate tax deduction of up to $1.80 per square foot for certain energy-efficient improvements on properties greater than 20,000 square feet. The deduction is available for certain energy-efficient components placed into service from December 31, 2005 through December 31, 2013 as part of the interior lighting systems; the heating, cooling, ventilation and hot water systems; or the building envelope. The maximum deduction is $1.80 per square foot which is comprised of the following subsystem deductions:

    • HVAC - $0.60 per square foot
    • Interior lighting - $0.60 per square foot
    • Building envelope - $0.60 per square foot

A full tax deduction of $1.80 per square foot is available if the improvements reduce the building’s total annual energy and power costs by 50% or more compared with a referenced benchmark. To qualify for the Section 179D tax deduction, the IRS requires an independent third party energy tax study. A partial deduction If the 50% energy savings threshold isn’t met, a partial deduction of $0.60 per square foot for each qualifying component can be taken if the following minimum energy savings percentages are achieved:

Summary of Energy Saving Percentages
For property placed in service
(Note 1) After Dec. 31, 2008, and before March 12, 2012 On or after March 12, 2012, and before Jan. 1, 2014
Interior lighting systems 20% 25%
Heating, cooling, ventilation and hot water systems 20% 15%
Building envelope 10% 10%

Note 1- Until December 31, 2013, taxpayers may use either the energy savings percentages effective after December 31, 2008 or those percentages effective on or after March 12, 2012. The sum of all partial Section 179D deductions can’t exceed the excess, if any, of a) the product of $1.80 and the square footage of the building ,over b) the aggregate amount of the Section 179D deductions allowed for the building for all prior taxable years. For example, assume the building’s square footage is 120,000 and in previous years $100,000 in Section 179D deductions were taken for the building. In 2013, Section 179D partial deductions for the building can’t exceed $116,000 [($1.80 × 120,000) – $100,000]. Staying on top of it The Section 179D deduction was previously extended beyond its original deadline and could be extended again. Your tax advisor can help you stay on top of any additional extension and other tax incentives (such as those for solar energy) that could help you improve your bottom line with energy-efficient construction.

SPOTLIGHT ON Marks Paneth

Marks Paneth SURVEYS REAL ESTATE PROFESSIONALS ON HURRICANE SANDY’S IMPACT ON PROPERTY VALUES IN LOWER MANHATTAN Crain’s New York Business has highlighted an Marks Paneth survey, which asked more than 100 New York commercial property owners, brokers, managers, attorneys and other real estate executives how Hurricane Sandy affected property values in Lower Manhattan. Fifty-six percent of respondents believed the storm hurt commercial real estate property values and 20 percent said they believed values have been “permanently lowered.” William Jennings, Partner-in-Charge of the Marks Paneth Real Estate Group, was quoted in the article. Marks Paneth APPOINTS NEW PARTNER AND PRINCIPALS Marks Paneth has named a new partner and two new principals:

Based in our headquarters in Manhattan, these new appointees have significant experience advising on matters that span international taxation, the real estate industry and economic analysis related to labor and employment disputes, respectively. Please click here to read more. ROSENBERG, NEUWIRTH & KUCHNER, CPAS, P.C. JOINS Marks Paneth We are pleased to announce that as of January 1, 2013, Rosenberg, Neuwirth & Kuchner, CPAs, P.C. (RNK) has joined Marks Paneth. RNK is highly regarded for its expertise serving organizations involved in creative and performing arts, including Broadway and other theater, TV, music and literary works. The firm also has significant real estate, tax planning for high-net-worth individuals and corporate audit (including employee benefit plans) practices. Please click here to read more.


About William H. Jennings

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William H. Jennings, CPA, is a Senior Consultant in the Real Estate Group at Marks Paneth LLP. Mr. Jennings served on the Marks Paneth Executive Committee, which sets policy and strategy for the firm, from its inception until 2019. He is the former Partner-in-Charge of the Real Estate Group and the former Partner-in-Charge of the firm’s Boca Raton, Florida office.   With over 40 years of experience in public accounting and a keen focus on the real... READ MORE +


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