TAX PLANNING TIPS FOR SYNDICATORS
The Internal Revenue Code and California Proposition 13 have long favored real estate as one of the most tax efficient asset classes, along with municipal bonds. Many syndicators (deal promoters or sponsors) have been able to make terrific historic returns for their investors and for themselves when using the tax code wisely and leveraging off of banks to increase the internal rate of return. Besides the basics of the depreciation allowance and the California Proposition 13 rule that real property taxes can only be increased by 2% per year, the following are some tips for California based syndicators to consider when structuring deals.
Choice of Entity
It seems that the “go to” entity choice for holding real estate in the United States is always the limited liability company. For syndicators that either: (i) own real estate in California, (ii) have over half of the membership interests in an entity owned by California residents, or (iii) the manager/ managing member is a California resident or an entity owned by a California resident, then the entity will have to register with the California Secretary of State and pay the Franchise Tax Board tax of $800. Additionally there is a Gross Receipts “Fee”, which starts out at $900 when the LLC’s gross receipts reach $250,000 and rises to $2,500 when gross receipts reach $500,000, $6,000 when gross receipts reach $1,000,000 and tops out at $11,790 when gross receipts exceed $5,000,000. Although this is a small tax, paying any amount over $800 is unnecessary and the amounts add up over time. Limited partnerships don’t pay gross receipts tax, only the $800 annual tax. If your deal generates $1,000,000 in gross rent annually, why give the California Franchise Tax Board an extra $6,000 just for the pleasure of doing business in California? The correct way to structure the deal is using a limited partnership and using a limited liability company for the general partner so that the general partner receives limited liability (because in a limited partnership only the limited partners receive limited liability).
Net Operating Losses
The limited partnership agreement or the operating agreement expressly spells out, in often complicated language, the tax treatment of the syndication. One of these items is who is entitled to the net operating losses. Usually over looked, this can be an important point. If I am an investor I would like at least my pro-rata share of the net operating losses. If I am a syndicator I would like to keep all of the net operating losses to offset other gains I might have. If I am a syndicator and my investors are wealthy retired people who can’t use the net operating losses because they are already hit with the average minimum tax, then they won’t mind if I keep all of the net operating losses.
One of the great tax benefits of real estate investments is that when you refinance a property and take out your proceeds, whether for personal or investment purposes, the refinance proceeds are considered tax free income to you. The only drawback is that your basis in the investment is lowered by the refinance proceeds. Additionally, over the life of the investment the basis is lowered by the depreciation expense. After many years of depreciation, mortgage interest deductions and multiple large refinancing, it is not uncommon for investors to have a negative basis (negative capital account) in the investments. What does this mean? Phantom income, if you have a large negative capital account, when you sell the asset and pay off the debt, you may have to come out of pocket to pay the capital gains tax! 1031 exchanges only delay the inevitable taxes that will be paid and are not real solutions to the problem. The only solution to get around this tax problem is to not divest of the investment during your lifetime and leave it to your heirs at stepped up basis on your death.
Many investors purchase real property in their name individually and later transfer it to a limited liability company once they get around to it. Syndicators enter in Purchase and Sale Agreements in their holding company’s name and then create a single purpose entity during the escrow period. Occasionally issues arise and a syndicator might have to close escrow in the holding company’s name or switch entities once the deal is finally set up. Switching entities after escrow closes or transferring property from an owner’s name individually to an entity is suicide for long term California real property tax planning. California Revenue and Taxation Code 64(d) states:
“If property is transferred … to a legal entity in a transaction excluded from change in ownership by Section 62(a)(2), then the persons holding ownership interests in that legal entity immediately after the transfer shall be considered the "original coowners." Whenever shares or other ownership interests representing cumulatively more than fifty percent of the total interests in the entity are transferred by any of the original coowners in one or more transactions, a change in ownership of that real property owned by the legal entity shall have occurred, and the property that was previously excluded from change in ownership under the provisions of Section 62(a)(2) shall be reappraised.”
California Revenue and Taxation Code 62(a)(2) states:
“Any transfer between an individual or individuals and a legal entity or between legal entities, such as a cotenancy to a partnership, a partnership to a corporation, or a trust to a cotenancy, that results solely in a change in the method of holding title to the real property and in which proportional ownership interests of the transferors and transferees, whether represented by stock, partnership interest, or otherwise, in each and every piece of real property transferred, remain the same after the transfer.”
What this means is if you previously used a 62(a)(2) exclusion (proportional interest exclusion) as an exemption for a change in ownership, anytime more than fifty percent of the cumulative interest changes than there is a change in ownership aka the “taint”. On the other hand, if the property was purchased in the name of the correct entity and the entity never changed, then under current California law you can change over fifty percent of the underlying ownerships interests so long as one owner does own over fifty percent.
Let’s look at a hypothetical: Back in 2006 Michael Dell purchased the beautiful Fairmont Miramar Hotel on Ocean Avenue in Santa Monica for $200,000,000. He did not purchase the real property, he purchased the limited liability company that owned the real property. A limited partnership owned by Michael Dell purchased forty-two and one half percent, his wife’s separate property trust purchased forty-nine percent and his syndicated investment fund purchased eight and one half percent. Since he or his other buyer entities did not individually acquire more than fifty percent of the underlying ownership interest, there was no change in ownership. The Los Angeles County Assessor literally said that this was “too good to be true” and reassessed the property ignoring California law. The Assessor lost on appeal after litigating, Michael Dell was refunded his over payment of property taxes from the large but incorrect change in ownership reassessment, he was awarded his large attorney fees and to this day he is paying property taxes based on a 1999 tax basis (the years the seller purchased the hotel) of $86,000,000. If you have stayed at the hotel and thought that the bathrooms and the rooms are small and that the building could use a major remodel, you might be in for a long wait because the new construction from a major remodel will cause a reassessment.
The taint: In the above Michael Dell example, let’s say instead that if Michael Dell’s sellers had originally purchased the hotel in their names individually or in a different entity’s name and later transferred the hotel to entity that was purchased by Michael Dell, the hotel would have been tainted and a change in ownership would have occurred when he purchased the entity that owned the hotel. Since some syndicators transfer, sell or change their investors over time, it is very important that the underlying assets not be tainted. This can be accomplished by insuring the syndication is properly set up prior to closing escrow on the property.
The information in this article is intended to be a general description of tax laws and is not advice as to any transactions, nor is this article advice to any person or to any client and should not be relied upon as such. If you or your client desire to receive specific legal or tax advice on a specific transaction, then please call Caldwell Law at (818) 992-2921.