Special Allocations and Basis Limitations: A Guide for Real Estate Funds

Taxation is a complex subject in real estate funds. The flexibility of the partnership model means income and losses can be allocated in many ways, allowing fund managers to provide investors with a range of tax benefits.

This differs significantly from more rigid entity structures like S corporations, which require income and losses to be distributed among shareholders in proportion to their ownership percentage. By using special allocations, real estate funds can allocate income and losses to better align with the needs of their investors.

However, navigating the regulations governing special allocations can be a complicated task. It’s vital that partners understand concepts such as basis limitations, which limit the amount of losses partners may deduct.

In this guide, we’ll explore the interplay between special allocations and basis limitations and outline the factors real estate funds and investors must keep in mind. By considering these issues before setting up a real estate fund, managers can deliver the intended tax consequences to their investors — and minimize the potential for unexpected tax liabilities, reduced returns and potential conflicts among partners.

An Introduction to Special Allocations

Special allocations allow partnerships to distribute income and losses in a way that differs from each partner’s ownership interest in the fund. Exactly how these allocations are distributed will be specified in the partnership’s operating agreement.

Special allocations are common in real estate funds. Preferred returns (commonly called waterfall provisions), which typically see investors receive a specified rate of return on their investment before a sponsor realizes any profits, are one example of a special allocation. Carried interest, (commonly called promote), which is a share of the profits earned by the sponsor of a fund, is another example.

Special allocations are often used to attract investors (through preferred returns) or reward strong performance (through carried interest). However, they also have very important tax implications. Through depreciation and other methods, many real estate funds produce tax losses that are allocated among partners. Partners, in turn, can use these losses to offset their own taxable income.

These losses can be allocated in several ways, but they must keep with the fundamental economic principles of the partnership. Sometimes this isn’t the case; for instance, all losses and expenses are allocated to one person in a 50:50 partnership that is intended to have equal economics between the two partners. In this situation, the IRS may recast these allocations and tax all partners based on their ownership percentage — regardless of the income they received.

The Economic Effect Test

Under IRC §704(b), special allocations must have “substantial economic effect” to be permissible. In a nutshell, this means allocations should be tied to the economic realities of the partnership and should not be structured purely to provide tax benefits. The rules governing these allocations should be defined in the partnership’s operating agreement.

For recourse liabilities, losses are allocated based on the partners’ economic risk. However, for non-recourse debt, including qualified non-recourse debt often used in real estate partnerships, losses can be allocated among partners according to special allocations defined in the partnership agreement, provided certain requirements are met.

These allocations don’t necessarily reflect each partner’s actual economic risk, as no partner bears personal risk for non-recourse debt. Partners can be allocated losses attributable to qualified non-recourse debt even if they don’t personally guarantee the debt, allowing for more flexible allocation strategies in real estate partnerships.

Generally, the greater the level of risk an investor is willing to take, the greater the tax benefits they stand to receive. However, there is another concept that limits losses: basis limitations.

Basis Limitations in Real Estate Funds

Investors in real estate funds are limited in the amount to which they can deduct losses by their economic basis in the partnership. Excess losses above this amount are generally allocated to other partners or suspended and carried forward into future tax years. Passive activity loss limitations may also limit a partner’s ability to use these losses.

A partner’s basis in a partnership is determined by the following:

• Their capital contributions and distributions
• Their share of the partnership’s income/losses
• Their share of the partnership’s liabilities

A partner’s basis evolves as they contribute additional capital, receive distributions, and are allocated income or losses. Tracking each partner’s basis is an important task for real estate funds so they can enable partners to plan for their tax liabilities. Special allocations offer funds the ability to structure their funds to help investors work around these limitations.

Strategizing Special Allocations When Setting Up a Real Estate Fund

It’s important to take a proactive approach toward special allocations when setting up a new real estate fund. Special allocations must be defined in the fund’s operating agreement. Funds must carefully consider the tax consequences of special allocations and ensure their investors understand the trade-offs associated with them.

On an ongoing basis, making special allocations requires a consistent approach to accounting that allocates income and losses among partners in a manner consistent with the operating agreement.

Both of these tasks can be complex for real estate fund managers, so it’s important to consult with real estate accounting professionals who are well-versed in navigating these complexities. At James Moore, our team of real estate CPAs brings significant experience advising real estate funds at every stage in their lifecycle.

To learn more about how we can support your real estate fund, contact a James Moore advisor today.

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