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Page 0 2015 REIT CFO and Tax Director Roundtables REIT partnership tax issues David A. Miller, Principal, Ernst & Young LLP Robert J. Crnkovich, Principal, Ernst & Young LLP Christine FioRito, Vice President-Tax, Equity Residential Eric Matuszak, Principal, Ernst & Young LLP

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Page 0 2015 REIT CFO and Tax Director Roundtables

REIT partnership tax issues ► David A. Miller, Principal, Ernst & Young LLP ► Robert J. Crnkovich, Principal, Ernst & Young LLP ► Christine FioRito, Vice President-Tax, Equity Residential ► Eric Matuszak, Principal, Ernst & Young LLP

Page 1 2015 REIT CFO and Tax Director Roundtables

Allocating nonrecourse liabilities

Page 2 2015 REIT CFO and Tax Director Roundtables

Overview of nonrecourse liability allocation rules

► Three tier allocation: ► Tier 1: Nonrecourse liabilities are allocated to each partner to the extent of that partner’s

share of partnership section 704(b) “minimum gain” ► Tier 2: Nonrecourse liabilities are allocated to each partner to the extent that each partner

would be allocated gain under section 704(c) if the partnership made a taxable disposition of all partnership property subject to nonrecourse liabilities in exchange for no consideration other than relief of the nonrecourse liabilities; ► Note that there is flexibility in allocating nonrecourse debt among properties subject to a liability

► Tier 3: The remaining nonrecourse liabilities are allocated to each partner in accordance with that partner’s share of partnership profits ► Partners are permitted to use a variety of methods to determine profits shares for this purpose

Page 3 2015 REIT CFO and Tax Director Roundtables

Example 1 – nonrecourse liabilities

► PRS refinances the contributed debt into a single nonrecourse liability encumbering both Asset #1 and Asset #2

► What flexibility does PRS have in allocating the $90 refinanced liability?

B A

50% 50%

PRS

R/E Asset #2: FMV = $100 Basis = $20 Debt = $45

R/E Asset #1: FMV = $100 Basis = $60 Debt = $45

Page 4 2015 REIT CFO and Tax Director Roundtables

Example 1 – nonrecourse liabilities (cont.)

► Single nonrecourse liability encumbering multiple properties ► For purposes of Tier 2, the liability must be allocated among the encumbered properties

using any “reasonable method” ► Once allocated, the liability is treated as separate loans encumbering separate properties

► PRS may divide the $90 liability among Asset #1 and Asset #2 using any reasonable method

► PRS may not allocate to any property an amount of the liability that, when combined with any other liability allocated to the property, exceeds the fair market value of the property

► Consistency rules apply ► Example assumes the section 704(c) remedial allocation method is not used

Page 5 2015 REIT CFO and Tax Director Roundtables

Example 1 – nonrecourse liabilities (cont.)

PRS’s Allocation of the Liability between Asset #1 and Asset #2

Tier 1 Allocation

Tier 2 Allocation

Tier 3 Allocation*

Total § 752 Liability Allocation

Equal allocation between R/E #1 and R/E #2 (i.e., $45 to each asset)

$0; (No minimum gain/book value exceeds debt)

Partner A: $0 Partner B: $25 ($45 liability; $20 basis)

Partner A: $32.50 Partner B: $32.50

Partner A: $32.50 Partner B: $57.50

$90 allocation to R/E #1; $0 allocation to R/E #2

$0 Partner A: $30 ($90 liability; $60 basis) Partner B: $0

Partner A: $30 Partner B: $30

Partner A: $60 Partner B: $30

$0 allocation to R/E #1; $90 allocation to R/E #2

$0 Partner A: $0 Partner B: $70 ($90 liability; $20 basis)

Partner A: $10 Partner B: $10

Partner A: $10 Partner B: $80

* There are four allowable methods for allocating tier 3 liabilities, with considerable flexibility. This example assumes a pro rata allocation.

Page 6 2015 REIT CFO and Tax Director Roundtables

Applying section 743(b) to partnerships with contingent liabilities

Page 7 2015 REIT CFO and Tax Director Roundtables

Contingent liabilities: Reg. § 1.752-7

► “-7 liabilities” (i.e., liabilities described in Treas. Reg. § 1.752-7) consist of any fixed or contingent obligation to make payment that is not otherwise treated as a liability for tax purposes ► (e.g., -7 liabilities do not include liabilities that create tax basis, such as loans, the proceeds

of which are used to purchase property)

► The amount of a -7 liability is generally the amount of cash that a willing assignor (i.e., current obligor) would pay to a willing assignee (i.e., future obligor) to assume the obligation in an arm’s-length transaction

Page 8 2015 REIT CFO and Tax Director Roundtables

Section 743(b) and Reg. § 1.752-7

► Section 743 requires a partnership with a section 754 election or with a substantial built-in loss to adjust the basis of its property upon a transfer or an interest in the partnership by sale, exchange, or death

► Section 743(b) gives the buyer of a partnership interest the effect of a fair market value basis in its share of partnership assets

► The buyer’s section 743(b) basis adjustment is allocated among the assets of the partnership in accordance with section 755 and its regulations

► -7 liabilities are treated as section 704(c) property under Treas. Reg. § 1.704-3(a)(12)

► The regulations under sections 743 and 755 do not expressly provide that contingent liabilities also qualify as property for purposes of sections 743 and 755

Page 9 2015 REIT CFO and Tax Director Roundtables

Example 2 – taxable partnership interest acquisition

► Y’s adjusted basis in the OP interest acquired from X is $50 ► Y’s net section 743(b) adjustment will be allocated among OP’s assets under Reg. § 1.755-1

* Numbers reflect X’s share of each item.

OP

X Sale of OP interest

Y

Real Estate*

$50

FMV: $60 Basis: $20 -7 liability: $10 Debt: 0

Page 10 2015 REIT CFO and Tax Director Roundtables

Calculation of Y’s section 743(b) basis adjustment

► Does the -7 liability constitute “loss” property for purposes of section 743(b)? ► Yes

► Y’s share of previously taxed capital is $20: ► $50 Y would receive in liquidation of OP in the hypothetical transaction described in Reg. § 1.743-1(d) (the

“Hypothetical Sale”) ► Less: $40 of gain allocated to Y from the Hypothetical Sale ► Plus: $10 of tax loss allocated to Y from the Hypothetical Sale

► Y’s basis adjustment under section 743(b) is $30 ► No

► Y’s share of previously taxed capital is $10: ► $50 Y would receive in liquidation of OP in the Hypothetical Sale ► Less: $40 of gain allocated to Y from the Hypothetical Sale ► Plus: $0 of tax loss allocated to Y from the Hypothetical Sale

► Y’s basis adjustment under section 743(b) is $40

Page 11 2015 REIT CFO and Tax Director Roundtables

Allocation of Y’s section 743(b) adjustment

► Assuming the -7 liability is properly treated as loss property under sections 743 and 755, there might be two ways to allocate the adjustment

► Gross allocations to each item ► Increase the basis of the real estate by $40 ► “reduce basis” in the -7 liability (i.e., eliminate any deduction) by $10 for a net of $30.

► Net allocation to the real estate ► Increase the basis of the real estate by $30 ► Do not alter the -7 liability

Page 12 2015 REIT CFO and Tax Director Roundtables

Preferred returns in fund structures

Page 13 2015 REIT CFO and Tax Director Roundtables

Overview

► In a typical fund structure (real estate, private equity, etc.) investors contribute capital in exchange for an interest that entitles such investor to both a common and a preferred return

► In a given year, the character of the preferred return income can vary depending on whether the payment is considered to be a distributive share of partnership income or a guaranteed payment under section 707(c)

► Section 707(c) states: ► To the extent determined without regard to the income of the partnership, payments to a

partner for services or the use of capital shall be considered as made to one who is not a member of the partnership, but only for the purposes of section 61(a) (relating to gross income) and, subject to section 263, for purposes of section 162(a) (relating to trade or business expenses)

Page 14 2015 REIT CFO and Tax Director Roundtables

Section 707(c) Regulation example

► Under an existing regulation example, a partner entitled to receive the greater of a percentage of partnership income or a specified amount is treated as receiving a guaranteed payment only to the extent the allocated share is less than the minimum amount

► For example, if a partner is to receive the greater of $10,000 or 20% of partnership income (determined without regard to the payment) and the partnership reports $20,000 of income for the year, the partner would be entitled to $10,000. Under the existing regulations, $4,000 of the payment (20% of $20,000) would be characterized as an allocable share of income and $6,000 would be treated as a guaranteed payment under section 707(c).

Page 15 2015 REIT CFO and Tax Director Roundtables

Section 707(c) Regulation example (cont.)

► A proposed regulation package would modify the current regulation example to state that the entire minimum amount ($10,000) is to be treated as a guaranteed payment in light of the fact that the minimum amount is not subject to significant entrepreneurial risk

Page 16 2015 REIT CFO and Tax Director Roundtables

Example 1: positive gross income – positive net income

► A contributes $20 of cash in exchange for a 20% common interest and B

contributes $80 of cash in exchange for a 10% preferred return and an 80% common interest

► If PRS earns $100 of net income in year one (made up of $200 of gross income and $100 of expenses), is any of B’s $8 preferred return a guaranteed payment?

PRS

B A

80% 20%

$80 Cash $20 Cash

Page 17 2015 REIT CFO and Tax Director Roundtables

Example 2: positive gross income – negative net income

► A contributes $20 of cash in exchange for a 20% common interest and B

contributes $80 of cash in exchange for a 10% preferred return and an 80% common interest

► If PRS loses $100 of net income in year one (made up of $100 of gross income and $200 of expenses), is any of B’s $8 preferred return a guaranteed payment?

PRS

B A

80% 20%

$80 Cash $20 Cash

Page 18 2015 REIT CFO and Tax Director Roundtables

Example 2: negative gross income – negative net income

► A contributes $20 of cash in exchange for a 20% common interest and B

contributes $80 of cash in exchange for a 10% preferred return and an 80% common interest.

► If PRS loses $100 of net income in year one (made up of $0 of gross income and $100 of expenses), is any of B’s $8 preferred return a guaranteed payment?

PRS

B A

80% 20%

$80 Cash $20 Cash

Page 19 2015 REIT CFO and Tax Director Roundtables

New guidance Varying interest regulations

Page 20 2015 REIT CFO and Tax Director Roundtables

Varying interest regulations

► Final and proposed regulations (T.D. 9728) were issued on 31 July 2015 ► Effective date

► Generally applicable to partnership tax years that begin on or after 31 July 2015 with several exceptions for existing partnerships

► The proposed regulations generally apply to partnership tax years that begin on or after the date they are published as final

Page 21 2015 REIT CFO and Tax Director Roundtables

Varying interest regulations (cont.)

► The final regulations reorganize Treas. Reg. § 1.706-4 ► Notable changes include:

► Any partnership where capital is not a material income producing factor is now eligible to rely on the service partnership safe harbor (as opposed to those partnerships meeting the narrower definition of service partnership set forth in the 2009 proposed regulations)

► Partnerships are now allowed to use different methods for different ownership changes, such as closing the books for one change and pro-rations for another change, provided that the overall combination of methods is reasonable based on the overall facts and circumstances

► Partnerships are now permitted to perform regular monthly or semi-monthly interim closings, and to prorate items within each month or semi-month, as applicable

► Additional items have been added to the list of extraordinary items that must be taken into account by the persons that were partners when the item was incurred (rather than being eligible for proration)

Page 22 2015 REIT CFO and Tax Director Roundtables

New guidance Proposed Regulations under section 707(a)(2)(A)

Page 23 2015 REIT CFO and Tax Director Roundtables

► Section 707 covers transactions between a partner and partnership ► The general rule provides that if a partner engages in a transaction with a partnership other

than in his capacity as a member of such partnership, the transaction shall, except as otherwise provided in section 707, be considered as occurring between the partnership and the partner as if the partner was one who is not a partner

► Section 707(a)(2)(A) grants the Treasury authority to issue regulations under which a purported allocation and distribution to a service partner are recharacterized as a "disguised" payment for services and consequently treated as ordinary compensation income ► This grant of authority to the Treasury was intended to:

► Prevent partners from receiving a de facto deduction for capital expenditures; and ► Prevent partners from converting ordinary income into capital gains

General background on section 707(a)(2)(a)

Page 24 2015 REIT CFO and Tax Director Roundtables

► Revenue Procedure 93-27 (“Rev. Proc. 93-27”) provides a safe harbor to the taxation of the service provider upon the receipt of profits interests in connection with the performance of services. The safe harbor currently provides that the receipt of a profits interest in return for the performance of services will not be taxable unless either: i. the profits interest relates to a substantially certain and predictable stream of

income from partnership assets; ii. the partner disposes of the profits interest within two years of receipt; or iii. the relevant partnership is a publicly-traded partnership.

General background on Revenue Procedure 93-27

Page 25 2015 REIT CFO and Tax Director Roundtables

► In a common management fee waiver arrangement, the general partner (“GP”) of an investment fund is permitted to satisfy all or a portion of its capital commitment to the fund with deemed capital contributions, and the fund managers similarly are deemed to satisfy all or a portion of their capital contribution obligations to the GP. In connection with the deemed contribution, there is a reduction in the management fee payable by the fund

► The GP is entitled to a priority allocation of subsequent net profits of the fund, if and when they occur, equal to the amount of its deemed capital contributions to the fund

General background on management fee waivers

Page 26 2015 REIT CFO and Tax Director Roundtables

► If such priority profit allocation includes net long-term capital gain or qualified dividend income, the fund’s GP (and its partners) would be subject to tax at the lower US federal capital gains tax rate as compared to the higher ordinary income tax rate that otherwise would have applied to the waived management fee

► The priority allocation may also result in deferral of the tax that would have been due if management fees had not been waived

General background on management fee waivers (cont.)

Page 27 2015 REIT CFO and Tax Director Roundtables

Management fee waivers illustration

Investment Fund

GP

Limited Investors

Management Co.

2% Management. Fee Waived

Investment Management

Firm 100%

100%

99% Capital

80% Profit

20% Profit

► Converts ordinary income of management fees into long-term capital gains

1% Deemed Contribution

Page 28 2015 REIT CFO and Tax Director Roundtables

► The Proposed Regs (issued on 22 July 2015) recharacterize certain allocation and distribution agreements as disguised payments for services. The Proposed Regs provide that the analysis of recharacterization is based upon the facts and circumstances. Six non-exclusive factors may indicate a disguised payment for services: ► Critical Factor: lack of significant entrepreneurial risk ► Secondary factors

1. Timing of allocation and distribution 2. Transitory partnership interest 3. Obtaining tax benefit 4. Relative size of the partnership interest 5. Different allocations and distributions for different services

Proposed Regulations under section 707(a)(2)(A) (the “Proposed Regs”)

Page 29 2015 REIT CFO and Tax Director Roundtables

► The Proposed Regs are effective on the date final regulations are published ► However:

► The Proposed Regs further provide that taxpayers should look to section 707(a)(2)(A) and its legislative history in determining the consequences of arrangements entered or modified before the Proposed Regs are finalized, noting that the IRS and Treasury believe that the Proposed Regs generally reflect Congressional intent as to which arrangements are appropriately treated as disguised payments for services. Such language indicates that the IRS believes it could apply the principles of the Proposed Regs to arrangements not subject to the final regulations. Accordingly, taxpayers under IRS audit should expect the government to argue for the application of the principles articulated in the Proposed Regs, even before they are finalized.

Proposed Regs – effective date

Page 30 2015 REIT CFO and Tax Director Roundtables

► Significant entrepreneurial risk is the most important factor and is accorded more weight than the other factors

► Whether an arrangement lacks significant entrepreneurial risk is based on the service provider’s entrepreneurial risk relative to the overall entrepreneurial risk of the partnership. The Proposed Regs list five arrangements that are presumed to lack significant entrepreneurial risk (and therefore, constitute a disguised payment for services) unless facts and circumstances establish otherwise by clear and convincing evidence.

Significant entrepreneurial risk

Page 31 2015 REIT CFO and Tax Director Roundtables

► The five arrangements that are presumed to lack significant entrepreneurial risk are as follows: 1. Capped allocations of partnership income, if the cap is reasonably expected to apply in

most years 2. Allocations for a fixed number of years under which the service provider’s distributive

share of income is reasonably certain 3. Allocations of gross income items 4. Allocations that are: (i) predominantly fixed in amount, (ii) reasonably determinable under

all the facts and circumstances, or (iii) designed to ensure that sufficient net profits are highly likely to be available to make the allocation to the service provider

5. Arrangements in which a service provider either waives its right to receive payment for the future performance of services in a manner that is non-binding or fails to timely notify the partnership and its partners of the waiver and its terms

Significant entrepreneurial risk (cont.)

Page 32 2015 REIT CFO and Tax Director Roundtables

► The Proposed Regs list five secondary factors (the first four of which are stated in the legislative history of section 707(a)(2)(A)) that may be relevant to the characterization of the arrangement : 1. Whether the service provider holds or is expected to hold a transitory partnership interest or a

partnership interest for only a short duration 2. Whether the service provider receives an allocation and distribution in a time frame comparable to the

time frame that a non-partner service provider would typically receive payment 3. Whether the service provider became a partner primarily to obtain tax benefits that would not have

been available in a third-party capacity 4. Whether the value of the service provider’s interest in general and continuing partnership profits is

small in relation to the allocation and distribution 5. Whether the arrangement provides for different allocations or distributions for different services

received, the services are provided by one person or by related persons, and the terms of the differing allocations or distributions are subject to significantly varying levels of entrepreneurial risk

Secondary factors

Page 33 2015 REIT CFO and Tax Director Roundtables

► The Proposed Regs provide six examples to illustrate the aforementioned factors that may indicate a disguised payment for services

► The examples highlight the Treasury’s focus on significant entrepreneurial risk ► The Treasury, based on the examples, appears to be concerned with

management fee waiver arrangements where the allocation is reasonably determinable or is highly likely to be available ► Examples 5 and 6 provide insight into the kinds of facts and circumstances that are

meaningful in determining whether the critical concept of significant entrepreneurial risk has been satisfied by a particular management fee waiver

Examples provided by Proposed Regs

Page 34 2015 REIT CFO and Tax Director Roundtables

► The Proposed Regs also modify Rev. Proc. 93-27, narrowing its scope. ► The safe harbor will not apply to management fee waiver arrangements in which an

investment manager that provides services to a fund in exchange for a fee waives that fee in exchange for the issuance to an affiliate of the investment manager of an interest in future partnership profits calculated by reference to the amount of the waived management fees. ► The preamble to the Proposed Regs notes that the safe harbor is not applicable in the instance

above because: i. such transactions do not satisfy the requirement that receipt of a profits interest be for the provision of

services to or for the benefit of the partnership in a partner capacity or in anticipation of being a partner, and

ii. the service provider would effectively have disposed of the partnership interest (through a constructive transfer to the related party) within two years of receipt

Other modifications and implications

Page 35 2015 REIT CFO and Tax Director Roundtables

► Based on the narrowed scope of Rev. Proc. 93-27 it may be possible for the IRS to contend that even if a fee waiver arrangement by the investment manager has significant entrepreneurial risk, the receipt of an additional carried interest by a GP (or other entity) that was not the actual service provider is a taxable event

► Furthermore, the Proposed Regs will exclude from the safe harbor of Rev. Proc. 93-27 the issuance of a partnership profits interest in conjunction with a partner waiving payment of a substantially fixed amount including, for example, a fee based on a percentage of partner capital commitments

Other modifications and implications (cont.)

Page 36 2015 REIT CFO and Tax Director Roundtables

New guidance Notice 2015-54

Page 37 2015 REIT CFO and Tax Director Roundtables

► Treasury and the IRS announced the intent to issue regulations under ► Section 721(c) providing that section 721(a) will not apply when a US Transferor contributes

“Section 721(c) Property” to a “Section 721(c) Partnership,” unless the “Gain Deferral Method” described in the Notice is applied with respect to such “Section 721(c) Property” and

► Sections 482 and 6662 applicable to controlled transactions involving partnerships to ensure the appropriate valuation of such transactions

► Regulations under section 721(c) are effective immediately ► Section 721(c) Property

► Built-in gain (“BIG”) property, subject to certain exclusions

► Section 721(c) Partnership ► Domestic or foreign partnership if : (1) one or more foreign persons related to the US Transferor

is a direct or indirect partner in the partnership and (2) the US Transferor and related persons own more than 50% of the interests in partnership capital, profits, deductions, or losses

Notice 2015-54

Page 38 2015 REIT CFO and Tax Director Roundtables

► Remedial allocation method – partnership adopts the remedial allocation method with respect to all Section 721(c) Property contributed by US Transferors

► Proportionate allocation – in each taxable year in which there is remaining BIG on the Section 721(c) Property, the Section 721(c) Partnership allocates all items of section 704(b) income, gain, loss, and deduction with respect to such property in the same proportion

► Reporting requirements – the reporting requirements under sections 6038, 6038B, and 6046A are satisfied

► Acceleration event – the US Transferor recognizes BIG with respect to any item of Section 721(c) Property upon an “Acceleration Event” ► An “Acceleration Event” is any transaction that either would reduce the amount of remaining BIG that a US

Transferor would recognize under the Gain Deferral Method, or could defer the recognition of the BIG ► Subsequent contributions – The Gain Deferral Method is applied to all subsequent contributions

until the earlier of: (i) when no BIG remains on any Section 721(c) Property to which the Gain Deferral Method first applied; or (ii) 60 months after the initial contribution to which the Gain Deferral Method applied

Gain deferral method: requirements

Page 39 2015 REIT CFO and Tax Director Roundtables

► Notice requires proportionate allocations, but many other rules can require allocations that are not proportionate: ► Nonrecourse deductions must be allocated in accordance with debt allocation, which may

not be proportionate to other allocations ► Foreign tax expense must be allocated in accordance with taxable income, which may not

be proportionate to other allocations. ► Recapture items must be allocated in accordance with shares of deductions (including pre-

contribution deductions), which may not be proportionate to other allocations

► Notice provides that any deferral triggers BIG

► Accounting method changes? Are these deferrals? ► Recognition of loss? Is this a deferral? ► These hair trigger rules will probably cause great uncertainty in future planning

Gain triggers: proportionate allocations and deferral rule