Edited transcript from the teleseminarCarried Interest and Other Tax Matters Related to Syndication

Originally broadcast on June 25, 2020

Access the teleseminar here.

 

Kim Lisa Taylor:

Hello, everybody. Welcome to Syndication Attorneys, PLLC’s free monthly webinar, where we talk about topics of interest to real estate syndicators with opportunity for live questions and answers at the end of the call. I’m Attorney Kim Lisa Taylor. Charlene Standridge usually joins me on the call, but she’s not here today. But I do have a special guest who we will introduce in a moment.

Before we get started, please note that all of our calls will be recorded and may be used for future promotion, posted on our website or broadcast in a podcast available to the public. If you don’t wish to have your voice recorded, don’t raise your hand. Please schedule a one-on-one consultation at our website instead of asking questions during the live call.

Information discussed during this free teleconference is of a general educational nature and should not be construed as legal advice for your specific situation. This is a video and audio conference. We will use the video as long as we can, but sometimes it slows down the feed. So, if that happens, we will turn off the video and we’ll just go to audio only.

If you have questions, do please raise your hand. There should be a place in your dashboard where you can do that. There is also a chat box, so we’ll try to get to those as well. But it does make the presentation more interesting if we hear your voices, so we encourage you to not be shy. If you’d like to send a message to the host, you can do so in the chat box. Just make sure you select whether you want everyone to see your comment or just the host. You are free to comment to everyone if you want to. That’s totally fine, but please keep your comments respectful and just appreciate each other for who we are and try not to be mean.

Okay. So, today our topic is “Carried Interest and Other Tax Matters Related to Syndication.” Our special guest is Thomas Castelli from The Real Estate CPA. I’ve known Thomas for a while. Actually, they reached out to me a few years ago and asked me if I wanted to be on their teleseminar, and we’ve since struck up a relationship. I see them at different events where I speak and they’re speaking, and we’ve abled to collaborate on a few different projects. They’ve been a wealth of knowledge.

My husband is actually talking to them about some assistance with a syndicate that we did and closed out last year. So, I highly recommend that if you don’t feel like you have a CPA that understands what you’re doing, that they would be a fine choice for you to talk to and find out if it’s a good fit for you.

Thomas is an Advisory Manager for The Real Estate CPA. His team provides clients with top-notch tax and accounting advice and helps them build strategies, technology, and best practices. And guess what? His team also invests in real estate too, collectively owning 90-plus properties with about 300-plus units.

So, they get what you’re doing. I mean, that’s part of our thing too, is that we’ve been syndicators. We know what you’re doing. We’ve been through the training that you’ve been to. These guys have also attended some of those events, and they understand what you do, and they do it themselves. So, the best advisors are people who’ve been in your shoes.

I did want to talk a little bit and give you a setup. Thomas, can you say hi?

 

Thomas Castelli:

Hi. Oh, thank you for having me on today. It’s a pleasure to be here.

 

Kim Lisa Taylor:

Yeah, we’re so excited. So, before we get started, I just want to talk a little bit about the setup. I hope everybody can see my screen. The reason I put this up here is because this is the setup we’re going to talk about, and we’re talking about how taxes relate in this type of a structure.

So, just to go through the structure quickly, we usually have an investor level LLC that takes title to a property. This becomes the borrower on the bank loan. And then, that title holding entity or the investor LLC, we’ll call it, has two classes of members, usually Class A members who are all cash paying investors, including you, if you’re contributing cash to a deal, and the Class B members who is usually reserved for the management class. And the management class, the Class B, is usually going to carve out some ownership interest for themselves so that they can earn a share of the profits.

We also create a Manager LLC. The Manager LLC is going to be you and your management team again. So, the same people in the management LLC, and as Class B members. The manager will earn fees. We’re going to talk about what’s the difference between how the manager’s earnings get taxed and how the Class B members get taxed.

So, I’m just going to leave this structure up on the screen, so you guys can see that for the duration and keep referring back to it as we’re having these discussions with Thomas.

LLCs can be formed as a manager, a manager-managed LLC, and a member-managed LLC. All of the members are considered to be managing members. So, it’s a little bit different structure than a manager-managed LLC, where you have appointed a manager; that’s the structure we’re showing here on the screen, that is going to manage all the day-to-day affairs of the LLC and report to the investors or to the members. So, the manager-managed structure that we’re talking about is the one that you see on the screen.

Sometimes the manager LLC itself could be that member-managed structure where you just have several members with equal rights and duties, and there’s nobody appointed to be the specific day-to-day manager of that manager LLC. So, those are some more advanced structuring strategies, but they may come up during our discussion today.

If you have participated in limited partnerships in the past, this structure is identical the way that we structure limited partnerships. The only difference is instead of an investor LLC, you would have an investor LP, limited partnership. The manager would not be the manager, it would be a general partner. So, that would be the general partner but that’s still probably going to be an LLC. That’s still going to be structured either as member-managed or manager-managed itself.

And then, you could have Class A limited partners who are the cash-paying limited partners. And then, you could still carve out a Class B limited partnership interest for the management class. So, it doesn’t matter if we’re talking about LLCs or limited partners, we’re still looking at the same basic structure if you’re talking about buying real estate with investors.

So, let’s just dive into the questions. We’ve got a lot to cover. But Thomas, anything you want to add to any of that that I’ve just talked about?

 

Thomas Castelli:

No, I think we’re good. I think it’s a good frame to get started.

 

Kim Lisa Taylor:

Excellent. OK, so let’s just dive into the questions then. What is carried interest?

 

Thomas Castelli:

Right. So carried interest, sometimes called “carry,” is a share of the profits of an investment paid to the investment manager, in our case, most likely the general partner, as many people call it in this industry. In excess of the amount that manager contributes to the partnership, it’s very common in the real estate space. So, this is also known as a profits interest. It’s basically just compensation for ensuring that limited partners achieve a return on their investments.

And to carry, for example, would perhaps be, let’s just say that there’s a split. To make it simple, a split with the general partnership or the managers. They get 20% of the share of the investor LLC for making the property, for putting the deal together and managing it while the investors receive 80%. That’s just an example.

 

Kim Lisa Taylor:

Sure. So, back to our picture that’s on the screen, you’d have Class A members owning 80% of the company and Class B members owning the carried interest and that would be the 20% of the company. So, another name for this would be promote, or sometimes it’s the carve-out that the manager entity earns. So, carve-out, promote, profits interest, carried interest, in the tax world, they all pretty much mean the same thing, right?

Thomas Castelli:

Yeah.

 

Kim Lisa Taylor:

Yeah. OK. So, we’ve covered the Class B interest is where this carried interest typically occurred. Now, could you just have members and a manager and still have the same structure?

 

Thomas Castelli:

Sure. You don’t have to have the Class B members. We just like it because we like to give the Class B members some different rights than what the manager has, and we like to make that distinction.

 

Kim Lisa Taylor:

So, what does ordinary income tax mean and what triggers it?

 

Thomas Castelli:

Great question. So, ordinary income tax is simply income that’s taxed at the ordinary income rates of 0% to 37%. This ordinary income generally includes wages, business income, also sometimes called self-employment income, rental income, interest and royalties, very common income types that are taxed at the ordinary income tax rates.

 

Kim Lisa Taylor:

And does that include the self-employment tax?

 

Thomas Castelli:

Yeah, so basically, when you own a business or you’re self-employed, the first $137,000 of your income has an additional tax rather called the self-employment tax, which is 15.3%.

 

Kim Lisa Taylor:

So, the ordinary income tax with the self-employment tax would apply to certain things in a syndicate, but there’s other things that might not apply to. Is that correct?

 

Thomas Castelli:

Yes. So, when you’re dealing with a syndication, if the general partner or the manager, they receive acquisition fees, disposition fees, refinance fees, asset management fees, this is all considered ordinary income, and it’s taxed at the ordinary income rates of 0% to 37%. And in addition, in most structures, it’s also going to be subject to this self-employment tax as well.

 

Kim Lisa Taylor:

So, that self-employed tax would be in addition to the 0% to 37% that somebody is already paying?

 

Thomas Castelli:

Correct. Correct.

 

Kim Lisa Taylor:

All right. So, managers fees, so that would apply to all managers fees. What about cash flow distributions that are paid to the Class A members, the investors?

 

Thomas Castelli:

It’s not necessarily taxed on the distributions. You’re taxed on the rental income that’s allocated to you. So, to give a quick example, if there was $100,000, let’s just say, of rental income and the Class A members, the investors, were allocated 80% of that, so $80,000, they’re going to pay ordinary income tax rates on that $80,000. However, that said, it’s usually depreciation and different types of expenses that cause a loss. But if there were to be rental income, it’s going to be taxed at the ordinary income tax rates.

 

Kim Lisa Taylor:

And how are the Class A members taxed on distributions they receive from equity on sale of a property?

 

Thomas Castelli:

Capital gains. It’s going to be capital gains tax.

 

Kim Lisa Taylor:

So, we’ve just explored what ordinary income tax is. Let’s explore what capital gains tax is.

 

Thomas Castelli:

Absolutely. So, capital gains tax is the tax on the difference of the sales price of a capital asset such as real estate, and it’s adjusted basis, which is pretty much, long story short, it’s a purchase price less the depreciation that was taken on that asset during the time you held it. So, again, it’s a tax on the sales price. Basically, the tax on the gain from sales of a capital asset. And if you hold that asset for more than a year, so a year and day longer, you’re going to be taxed at the long-term capital gains tax rate.

If you’re making less than $19,000 a year, you’re getting taxed 0% on your long-term capital gains. Very rarely do we see that. If you’re making between that number and $434,000, give or take, if you’re single, you’re taxed at 15%. And if you’re above that $434,000 rate or $488,000, if you’re married, the capital gains tax rate is 20% for you. So, that’s the long-term capital gains.

Now, if you hold the capital asset for less than a year, then you’re going to be subject to the short-term. It’s going to be considered a short-term capital gain, and short-term capital gains held less than a year are taxed at the ordinary income tax rates.

 

Kim Lisa Taylor:

OK, so that’s going to apply if someone’s doing like a single-family fix and flip fund, and they’re turning properties in less than a year?

 

Thomas Castelli:

Yeah. And something to watch out for — not to get too deep into the weeds there — but when you’re flipping properties, you’re developing properties, there’s certain criteria that may classify you as a business, and your properties that you’re flipping or developing are no longer considered capital assets in the eyes of the tax code. It’s considered inventory. And thus, when you sell that inventory, your profit or what would otherwise be considered a gain is taxed as ordinary income at the ordinary income tax rates and can be subject to self-employment tax as well.

 

Kim Lisa Taylor:

What about Class B members? So, if the Class B members are getting cash flow distributions, how would those be taxed?

 

Thomas Castelli:

So, when you receive your carried interest or your profits interest, the income that you receive from your share of the interest retains its character. So, if you receive rental income, it’s going to be taxed at the ordinary income tax rates.

 

Kim Lisa Taylor:

And then, what about a Class B member that receives a distribution from equity earned on the sale of property?

 

Thomas Castelli:

Yeah, so that’s a great question. There’s a big debate in the community, the tax community, how this should be handled. After the Tax Cuts and Jobs Act of 2017 was enacted, they changed the section of the tax code that dealt with this — that if you have a carried interest, basically any asset needs to be held for at least three years or longer in order for you to get the long-term capital gains rates on that. Otherwise, if it’s held for less than three years and you have a carried interest, then it’s going to be taxed as a short-term capital gain, which is taxed at the ordinary income tax rates.

 

Kim Lisa Taylor:

So, short-term capital gains, less than three years for the Class B members, their sweat equity portion and their carried interest is going to apply for any asset that’s held less than three years?

 

Thomas Castelli:

Correct.

 

Kim Lisa Taylor:

And the long-term capital gains rates is going to be applied if you’re holding it for longer than three years?

 

Thomas Castelli:

Correct.

 

Kim Lisa Taylor:

So, from a tax perspective, if the manager is earning fees that are taxed at ordinary income rates, and then there’s a chance that at some point within the life of the syndicate that they’re going to earn some equity that’s going to be taxed at the long-term capital gains rates, does it matter that the manager … from a structural standpoint, can the manager get taxed at two different tax rates for its earnings?

 

Thomas Castelli:

Yeah. If the manager is receiving ordinary income from it in the form of fees, then yes, it’s very possible for them to be taxed at the ordinary income tax rates on their fees and taxed at the capital gains rates on a capital gain that they have.

 

Kim Lisa Taylor:

So, is it OK or is any reason that the manager itself shouldn’t just be the Class B member versus maybe having the members of the manager be the Class B members instead?

 

Thomas Castelli:

Yes. This is another great question and not to get too far into that because I could dive down a whole entire rabbit hole here. What some managers like to do is they might be considered what’s called a real estate professional for tax purposes. And if you’re a real estate professional for tax purposes, the losses you have from your rental activities can offset your ordinary income. Generally speaking, losses from rental activities are considered passive and can only offset other passive income.

So, what ends up happening is if a manager… So, let’s say the Class B… The manager, let’s just say, I don’t know, Tom Castelli takes Class B shares. So, I just take Class B shares of the… What am I trying to say?

 

Kim Lisa Taylor:

Shares of the entity?

 

Thomas Castelli:

Yeah, of the entity. Then what could happen is I maybe want to take that in my personal name and I personally want to sign on the loan. And the reason for this, if you’re getting qualified non-recourse debt, basically it increases your basis in the partnership because you’re signing on the loan. And when you increase your basis in the partnership, it allows you to take the losses. Because what ends up happening is the Class B members don’t really put in much capital, or if they do, it’s very little. And that prevents them from using the losses.

So, let’s just go back to our 80-20 example, all right, and let’s say there’s an investment loss. So, it’s $100,000 loss the first year of the partnerships and operation where the deal is going on. 80% of the losses are allocated to the partnership to the Class A members, 20% to the Class B members. The Class B members don’t have any basis, and the partnership will have a very little basis because they didn’t contribute any capital.

So, what’s going to happen is that’s going to create… Basically, it’s going to bring their capital account below zero and they’re going to be unable to take the losses against their active income. So, in that case, they may want to basically sign on their names on the Class B shares rather than having a manager LLC.

Now, let’s take it to the manager LLC side. Let’s say the manager LLC accepts all of the fees, acquisition fee, asset management fee, disposition fees, etc. What they do with the individual partners, the individual members of that management LLC, they can invest in, they could create their own S corporation. And what this S corporation allows you to do is it allows you to pay yourself a wage through the S corporation, and when you pay yourself a wage through the S corporation, you only pay the self-employment tax at 15.3% tax on the wage you pay yourself and not on the distributions from the S corporation.

So, in theory, what you could do is you would have an S corporation as a managing member that would take your interest in all the management entities that you’re a part of, and then all your fees, your fee income, would go into that S corporation, all that subjects, the ordinary income tax rates and self-employment tax could then pay yourself a wage out of the S corporation and mitigate part of the self-employment tax.

 

Kim Lisa Taylor:

Oh, that’s a bad strategy.

 

Thomas Castelli:

Yeah.

 

Kim Lisa Taylor:

This is why you want to have someone like Thomas on your team, so that when you’re coming to us and we’re structuring the deal with you, then you have a clear understanding of why it’s so important to structure the management entity in a very specific way as well as the investor level entity. And we’re really going to be talking to you more about how to structure the investor level entity, and then what you do within management who like to defer whatever your CPA advises on that, because of the very reasons that he’s talking about.

So, if I just circle back on some of the points that you made, so having the S Corp either as the manager itself or representing you as a member of the manager could be really beneficial, right?

 

Thomas Castelli:

It could be. Yeah. And you’re going to want to talk to your specific tax advisors on it because the full 15.3% self-employment tax is charged on your first $137,000, I think it’s $900 of income. And then after that, it goes to only 2.9% on the amount above $137,000. So, if you have another business that you’re operating or you’re employed, you might be paying mostly your self-employment income tax already through your other forms of income. And if that’s the case, now you’re only getting 2.9% tax on the excess. So, it may not make sense to have the S corporation depending on your individual circumstances.

 

Kim Lisa Taylor:

All right. Well, that’s pretty important. And so, circling back one more time on there could be times when it’s beneficial to take your Class B interests individually or in a separate LLC than the way that you’re participating in management. Did I hear that correctly?

 

Thomas Castelli:

Correct. Now, in that case, it would be because if you were to … to make the long story short, with an S corporation, if you just took everything in the S corporation, which is what some people tried to do at times, the S corporation when you sign on the loan, on that qualify non-recourse debt, it does not increase your basis in the S corporation. So, that’s part of the issue. But it does increase your basis in a partnership.

 

Kim Lisa Taylor:

So, if a member of the management team chip their Class B interest as an individual and then signed on the loan, that’s what’s required to get that increased…

 

Thomas Castelli:

Basis. Yeah. And that works for partnerships. It does not work the same way for S corporations.

 

Kim Lisa Taylor:

OK, but it does work for a partnership or an LLC, which is taxed as a partnership?

 

Thomas Castelli:

Correct.

 

Kim Lisa Taylor:

All right. So, I’m sure we’re going to get some follow-up questions on that one. But those are some pretty advanced strategies. I knew I was going to learn things on this call, so I’m super glad that we’re having it. But I am not going to try to give people that kind of advice. I’m going to send them to you.

So, all right, let’s talk about how all of these different income sources are reported. When does somebody within a syndicate get a 1099 versus a K-1? So, let’s start with how are you going to report taxes? Well, first of all, what is the difference between the 1099 and K-1? Let’s start with that.

 

Thomas Castelli:

So, K-1 is basically, it’s partnerships in S corporations, but in our case, let’s focus on partnerships that don’t pay taxes on their income, right? So, the partnership files a partnership tax return, Form 1065. And then, Form 1065 reports, hands out K-1s to each partner that reports the partner share of the income loss deductions credits of that partnership, and then the individual partner pays tax. They will file that K-1 with their individual tax return 1040 and pay tax based on their individual circumstances.

So, first, when it comes to a 1099, 1099 is, in this case, 1099-MISC. It just reports basically business income that’s paid to somebody. So, for example, with 1099, if I were to go hire a contractor to go do work on my property, I’m going to give him a 1099. They’re going to get a 1099 file for that income I paid them.

 

Kim Lisa Taylor:

All right, so let’s see where these different tax reports fit into the syndication structure. What would you give a manager LLC? Would that manager LLC receive a 1099 from the investor level LLC or a K-1 …

 

Thomas Castelli:

So, the manager LLC, in this case, doesn’t own anything, right? It’s just the manager. So, the fees, it would be a 1099 from the investor LLC to the manager LLC. And then the manager LLC, assuming it’s a partnership, it would then give K-1s out to each of their individual partners.

 

Kim Lisa Taylor:

So, what if the manager LLC also owned the Class B interest, would it receive a K-1 and a 1099?

 

Thomas Castelli:

So, in that case, it should receive just a K-1.

 

Kim Lisa Taylor:

Is there a way on the K-1 to characterize which income was paid for fees versus which income was paid for profits?

 

Thomas Castelli:

Yes. So, generally, Box 1 of the K-1 is going to have your ordinary income, basically just your regular income. And then in Box 2, you’re going to have your rental income or loss, so you share the profits. And real estate investment partnership are typically going to be rental income or loss, and that’s going to be reported in Box 2. And then, your share of any gains will be reported in a separate box. I don’t recall the number of that box off the top of my head, but it is on the K-1.

 

Kim Lisa Taylor:

And so, what about the Class A members, what tax report do they get?

 

Thomas Castelli:

They’re almost always going to get a K-1. It’s going to report their rental income or loss, and it’s also going to report their gains when that happens, when a property is sold.

 

Kim Lisa Taylor:

All right. So, we have our clients typically pay $1,000 for their Class B interest. It doesn’t matter if the Class B member is a manager LLC or if it’s the members of the manager, we want the Class B members to pay something for their Class B interest to establish an initial cost basis. Is that required?

 

Thomas Castelli:

So, technically, it’s not required. The IRS assumes that when you get the carried interest or the profits interest, it’s another term for it in the tax code, they assume that you didn’t contribute anything to it. However, there’s a few reasons why many people recommend that you do put something in even if it is as low as $1 or $1,000, and that’s simply because now it officially establishes that the Class B members have an interest in the partnership.

There are some cases where the IRS could argue or perceive that because there was no capital accounts, because if you didn’t put any money in it, you don’t have the capital account, that there is no partnership or you don’t have an interest, or there could be arguments over the timing of when that interest was received. So, it’s very common to see people putting in some form of capital just to clearly establish without any discrepancy that there is a partnership than where they do have their interest in the partnership.

 

Kim Lisa Taylor:

And I thought I heard you say that they could put in as little as $1?

 

Thomas Castelli:

Yeah. I mean, it’s just establishing that like, “Hey, look, we did…” It’s just a formality pretty much, and that’s about it.

 

Kim Lisa Taylor:

Well, great. So, what I’m getting out of this is it’s best if you guys pay something for your Class B interest. So, we’ll continue to advise that. All right, so let’s talk about… So, the structure we’ve been talking about so far is the syndicate structure.

And now, I want to talk a little bit about a joint venture or a member-managed LLC, and what would be maybe some difference, from a security standpoint, if somebody came to us and said, “We have three other investors, and we’re all going to put up money to be in this deal, or I’m going to keep 25% of the interest and the other three are going to put up money.” From a security standpoint, in order for our clients to call that a joint venture, all of the members have to be actively involved in generating their own profits. So, if all of the members of an LLC are actively involved, there are no passive members, how does that change the tax ramifications?

 

Thomas Castelli:

It really only changes it for someone who would otherwise, because everybody in this partnership would be a general partner by default. There is no carried interest anymore. It’s just a normal partnership interest, so you’re still going to be taxed at ordinary income rates on your rental income that would be received. And now, the long-term capital gains rates on the sale of assets is achievable on just holding the asset for a year and a day. There’s no worry about holding it for three years because that’s only applied to carried interest and not to… Just like your traditional partnerships or your ordinary partnerships.

 

Kim Lisa Taylor:

And I will, at some point, share with you anecdotally a nightmare story about being in a development project, the tax issues that arose from that. But that’s a different rabbit hole.

 

Thomas Castelli:

Just one more thing to add to that. So, that’s if you’re holding a property for buy and hold. Now, if you were flipping a property or perhaps developing a property, that’s when you can get into the situation that I described before where it’s considered inventory and not considered a capital asset. And then, your profits from that are considered business income. You’re taxed at the ordinary income tax rates in addition to the self-employment tax rates.

 

Kim Lisa Taylor:

Yes, I have experienced that. Not happily, I have to say. So, I think we talked about depreciation a little bit, but this question comes up all the time amongst my clients is, can the depreciation be allocated to the members disproportionately to their ownership interests? If I wanted to give all of the depreciation to all of Class A or maybe even just a subclass of Class A, can they do that?

 

Thomas Castelli:

The short answer is it is possible, but it’s extremely complicated to do and it could cause problems down the line when the property is liquidated, where the people who were disproportionately allocated, the losses could have to pay back part of their capital account, if it goes negative to the partnership depending on the structured … I mean, we could probably do a whole webinar on what’s called special allocations.

But long story short, it is possible. It’s very complicated. If you’re going to do something like that, consult with your tax advisor just prior to doing it because you don’t want to put yourself in a bad position where you have to pay back a certain amount of income out of your pocket or you just have really adverse consequences down the line.

 

Kim Lisa Taylor:

Yeah, nobody wants to pay money back. So, let’s try to avoid that at all costs. I think we’ve talked a little bit about this one. Next question was, is there ever a time that anyone should use a corporation to own real estate and that’s where you were talking about the S Corp … Well, OK, actually not. Is there a time that anybody should use a corporation to actually take title to the real estate versus an LLC or a limited partnership?

 

Thomas Castelli:

Generally, no. However, if you are full into the flipping and development category, a common strategy is to hold title to the property in an S corporation. And that’s because, again, that income can be classified as ordinary income and subject to self-employment tax. And by taking that title to the property and the S corporation, you’re able to pay yourself a wage out of the S corporation and help mitigate your exposure at 15.3%. self-employment tax. So, it’s very common to see people who fix and flip and develop properties hold their interest either directly or indirectly in N S corporation.

 

Kim Lisa Taylor:

OK, but they don’t use the S corporation to directly own the real estate, or do they?

 

Thomas Castelli:

So, yeah, they would either own the real estate directly in the name of the S corporation, or they’d have a single-member LLC that’s owned solely by the S corporation that would hold title of the property.

 

Kim Lisa Taylor:

Isn’t there some rule that an S Corp can’t have any non-U.S. members?

 

Thomas Castelli:

Yes, that’s correct.

 

Kim Lisa Taylor:

So, just be aware of that, if any of our listeners are thinking about having some foreign investors. What about using an S Corp to sell interests to investors, is there ever a time that anybody would want to do that?

 

Thomas Castelli:

It is possible people do that. I’m not sure that it’d be the best structure for it because with an S corporation, there is no ability to do special allocations. If you have an interest in this, if you have 5% interest in an S corporation, you get 5% of the income and loss. There’s no ability to change that. It’s just very straightforward. Whatever your ownership interest is in the S corporation is what your allocation is, and there is no way around that.

 

Kim Lisa Taylor:

OK, well, that’s good to know. All right, so before we go to Q&A, why don’t you give us contact information about how people can reach you?

 

Thomas Castelli:

Absolutely. So, you can reach me directly at thomas.castelli@hallcpallc.com, or you can visit therealestatecpa.com and you could fill out a form to have a free consultation with us, or check out The Real Estate CPA podcasts. That’s how you can get in contact with me.

 

Kim Lisa Taylor:

I think I need to subscribe to your podcast. I’ve learned a lot today. I hope everybody on the call has learned a lot today. I will give out our contact information in case anyone has to drop off the call. You guys are all in our database, or you wouldn’t have heard about our call.

Our Syndication Attorneys website has a ton of information about deal structuring, and you can get a copy of my book there. In case some of you don’t know, I did write a book called “How to Legally Raise Private Money.” It’s a number one Amazon bestseller, and you can get a free digital copy at our website, or you can buy it on Amazon if you want a soft copy, or Kindle, and we do have an audible version that we’re working on. So hopefully, we’ll have that done in a little while.

We also have a sister website called investormarketingmaterials.com. There you can see some of the types of investor marketing materials that we can help you create. I told people for years that they needed to have professional marketing materials written by professional editors and professional graphic designers. Couldn’t find anybody to do it, so we finally created our own company that does that. So, we have professional editors and graphic designers that can help you design professional marketing materials, including your websites, investment summaries, company brochures, educational programs, pitch decks, one-pagers. There’s a multitude of things there.

If you want help with branding your company, you’re just starting out in the syndication world and you want to create a brand for yourself, we can help you create that brand and then have it be consistent across your marketing materials. So, do check that out, investormarketingmaterials.com.

And at either of those websites, you can schedule an appointment. We’re happy to have a 30-minute conversation with you if you want to talk about how to get from where you are right now to where you want to be, or if you have a deal. And even if you don’t have a deal, we do have a pre-syndication retainer, where we can give you one-on-one legal advice and establish a relationship that would get you from where you are today to where you want to go.

You can also call us if you want to at 844-796-3428. That’s 844-SYNDIC8, S-Y-N-D-I-C and the number 8.

So, we are now going to go to some Q&A. We’ve got some questions in the queue.

Rob says, “Is there any downside to using cost segregation, for example, recapture later if we exit a deal sooner than anticipated?”

 

Thomas Castelli:

I don’t think there’s any there’s any downside. So, depreciation recapture is charged regardless of when you exit the property, so there’s no downside, especially when you exit. I don’t see any real downside of the timing of the exit on depreciation recapture.

 

Kim Lisa Taylor:

OK. So is cost segregation a good thing? Is it worth it?

 

Thomas Castelli:

I would say that our general advice is if you’re syndicating a property, you’re going to want to cost segregate the property almost every time. That’s our general advice. You could speak to your specific tax advisors on it, but we generally recommend that our clients do a cost segregation study on every property they syndicate.

 

Kim Lisa Taylor:

Right. OK. Next question is from Laura Lynn, “What if the investor invested through an IRA, how are the gains taxed? Still at the 37% rate?”

 

Thomas Castelli:

Yeah. This is always a great question. So, when you invest through a self-directed IRA, you are subject to a tax called the unrelated business income tax on the type of income that’s called UDFI, unrelated debt financed income. Unrelated debt financed income, there’s a complicated calculation to it, but long story short, it’s the percentage of the income that’s derived from debt financing.

So, for example, if you had $10,000 of rental income, let’s just say, and the property had debt financing of 75%, that’s 75% of that income. So, $7,500 would be considered UDFI.

Now, generally speaking, in most investment partnerships, at least the ones I’ve come across, you’re not going to have rental income in the first number of years. That’s because there’s usually a cost segregation study that’s performed or there’s a value-added component that is causing there to be a loss and you’re not paying any tax because there’s no income. Most the time you’re going to see the UBIT tax generated by UDFI on the sale of the asset.

Now, that said, usually it’s not material. You’ll still have a pretty good return on your investment despite this tax compared to the other assets you can invest in through self-directed IRA.

 

Kim Lisa Taylor:

OK, that’s great. Thank you so much. So Jackson asks, “Are refinancing proceeds taxed as ordinary income or capital gains?”

 

Thomas Castelli:

Refinance proceeds are not taxable, generally speaking, unless you take it in excess, unless the cash you take out of the partnership, if you have a partnership, is an excess of the basis in the partnership.

 

Kim Lisa Taylor:

Oh, that’s interesting. Good to know. And we usually recommend that any proceeds that are received from a refinance are used to repay the capital contributions of the Class A members. Any comments on that structure?

 

Thomas Castelli:

So, I’m pretty sure the reason why most people want to do that is so that the Class B members can basically pay off or reduce the interest of the Class A members, and then the Class B members could continue to keep the property.

 

Kim Lisa Taylor:

Or get a higher percentage of the remaining proceeds from cash. The other reason that we recommend it is because you are leveraging the property at a higher amount with a refinance and you want to pay down your initial obligation of what you have to pay back to your investors so that you don’t come up short when you sell, if the property hasn’t appreciated enough to pay back all those original capital contributions. If you have any preferred return, and you do return some of the capital from a refi to your investors, then from that point forward, you should only be paying any preferred returns on the unreturned capital contributions.

So, what that means is that if you’re paying 8% and somebody invested $100,000 and that you were paying them an 8% preferred return, they were getting $1,000 a year, then you give them 50% of their money back. From that point forward, you only owe them 8% preferred return on $50,000. And if there’s a split later on in the waterfall where Class B gets a cut, then now you’ve reduced your burden to Class A, so there’s a bigger portion of that split available to Class B. So, that’s another reason that we like to have you do that.

OK, great. Thanks, Jackson. That was a good question.

Rob asks, “Can a sponsor 1031 carried interest profit from Class B shares?” No, absolutely not. No. You can’t 1031 exchange real property interests for personal property interests. So, they’re two completely different things. If you’re trying to 1031 exchange, you have to have direct ownership in real estate if you’re wanting another real estate asset. So, you can’t use it in any way within your syndication structure. It has to be outside of your syndication structure. Anything you want to add to that?

 

Thomas Castelli:

Yeah. So, yeah, you can’t 1031 partnership interests but what you could do is that the general partner or the investment partnership as a whole said, “We’re going to go ahead and do a 1031 exchange.” You could 1031 exchange. So basically, let’s say the investment partnership was called ABC, LLC. ABC, LLC would have to sell the property and then take and buy the new property. So, it had to be the same partnership. It’s possible, but you have to be the same partnership.

 

Kim Lisa Taylor:

Right. And within that LLC, that’s 1031 exchanging its property, but it doesn’t matter. You can have whatever structure you want within the LLC that’s on the previous property as long as, I think, there needs to be some percentage of common members moving forward into the new purchase. Are you aware of that requirement?

 

Thomas Castelli:

Yeah. There’s a technical termination of a partnership if more than 50% of the partnership’s interest changes hands in any one year. The partnership will terminate, and the partnership will cease to exist. So, you just have to be careful with how many people you prefer to buy out, because sometimes people want out when this type of thing occurs. So, you just have to be careful there.

 

Kim Lisa Taylor:

And we have had some clients that have actually done a 1031 exchange. They went to their investors and said, “Hey, we have an opportunity. We have something else we want to buy, and we have a buyer for the property that we want to sell. So, do you guys want to just roll forward into the next purchase?” And the majority of the investors did, but a few of them wanted to be bought out. So, we carried the original investors over into the new property, and then re-syndicated the new property because some additional funds were needed. And then, with the additional funds paid out those investors that wanted to get out, but it wasn’t more than 50%. So, that was fine.

OK, great. Thanks, Rob, for that question and thank you, Thomas.

So, Nathan asks, “Do you still get taxed if all your investment is from an IRA or self-directed IRA?” I think we answered that, and the answer is yes, with the UBIT, right?

 

Thomas Castelli:

I think you’re still taxed if your investment is IRA or a self-directed IRA. But in this case, it’s the same thing. Your self-directed IRA is just an IRA. The custodian of that IRA allows you to invest in whatever assets you want, pretty much.

 

Kim Lisa Taylor:

So, Evan asks, “Can you run through an example of Class B recognizing both ordinary income and carried interest income?”

 

Thomas Castelli:

Yeah. So, one example of that would be the Class B members receive an allocation of rental income, and then they sell the property before the three-year period and they recognized the short-term capital gain, basically.

 

Kim Lisa Taylor:

So, what is the difference between short-term capital gain and long-term capital gain as far as… Is it a different percentage tax?

 

Thomas Castelli:

Yes, short-term capital gains are taxed at the ordinary income tax rates, whereas long-term capital gains are taxed at 0%, 15%, or 20%, depending on how much income you are.

 

Kim Lisa Taylor:

When would be an example of when it could be taxed at 0%?

 

Thomas Castelli:

I could just let you know right now. It’s a certain threshold of income. If you make… I hardly ever see it, so I always forget the number. But it’s if you make under $39,000 if you’re single, or if you make under $78,000 if you’re married.

 

Kim Lisa Taylor:

And then, what is the cutoff for the 15% or the 20%?

 

Thomas Castelli:

So, 15%, if you’re single, it’s $434,550. If you’re married, it’s $488,850. That will change every year.

 

Kim Lisa Taylor:

Ralph asks, “Please discuss phantom income.”

 

Thomas Castelli:

Phantom income?

 

Kim Lisa Taylor:

So, that’s when the partnership receives income but doesn’t make a distribution, and the income is then allocated to the investors on their K-1 so they still owe the tax on it. That’s my understanding.

 

Thomas Castelli:

Yeah, that’s pretty much what it is. Because what happens is when you have a partnership or an S corporation, the same case happens. You’re taxed on the income, your portion of the income that the partnership where the S corporation would produce, not necessarily what’s distributed to you. So, if the partnership doesn’t make any… If the partnership earns $1 million and keeps the $1 million in the partnership, it doesn’t make a distribution. You’re still taxed on your share of that $1 million despite the fact you didn’t receive any cash that year.

 

Kim Lisa Taylor:

Or if the syndicator stole all the money.

 

Thomas Castelli:

Yeah. Definitely that too. That can be bad.

 

Kim Lisa Taylor:

Let’s hope that doesn’t happen to anyone we know.

Stan asks, “What if a sponsor/manager receives an equity interest in lieu of fees, or if they receive no fees, then is the equity interest going to be taxed at ordinary income rates?”

 

Thomas Castelli:

It would just be part of the carried interest.

 

Kim Lisa Taylor:

Part of the carried interest? So, would there ever be a time that the IRS could argue that, “Hey, you need to be pay some ordinary income tax on some portion of these earnings because they were earned for your active role in management?”

 

Thomas Castelli:

No, that’s exactly what the carried interest is.

 

Kim Lisa Taylor:

OK. And again, that’s just going to matter on whether you keep it for three years, or short-term or long-term. All right. And it doesn’t matter because you’re always paying ordinary income tax on all earnings from cash flow.

 

Thomas Castelli:

Correct.

 

Kim Lisa Taylor:

Stan, if that didn’t answer your question, please type in a clarification.

Jesse asks, “What if someone withdraws their 401(k) with the COVID-19 exemptions, how will they be taxed when invested in a syndicate?”

 

Thomas Castelli:

So, it’s two separate equations. So, long story short, if you did the COVID-19 exemption, you could basically pay back, for the 401(k), you could pay back the [inaudible 00:54:26] took off of the 401(k). If you don’t pay it back, then that distribution you took from the 401(k) is going to be subject to a 10% penalty plus your ordinary income tax rates. It’s considered ordinary income if you don’t pay it out.

Now, the money you took to invest in the syndicate, that’s going to be taxed depending on the distributions from the syndicate. So, that could be taxed as ordinary income if it’s rental income or capital gains if it’s a capital gains income. That’s two separate things.

 

Kim Lisa Taylor:

Laura Lynn follows up an IRA question, “At what rate are the UBIT gains taxed in the IRA?”

 

Thomas Castelli:

They’re taxed at the trust tax rates, which I don’t know the full trust tax rates off the top of my head, but it goes from 0% to 37% on ordinary income, and 37% tax bracket starts at $12,500 of income.

 

Kim Lisa Taylor:

You’re going to pay income tax rate.

 

Thomas Castelli:

Yeah. And there’s also capital gains rates too. I’m pretty sure if I remember correctly, it’s also 0%, 15%, and 20%. I just don’t remember the rates.

 

Kim Lisa Taylor:

It all goes back to how did you earn the income, was it cash flow or was it from equity? OK. So, we have another attendee who says, “Please discuss the scenario when a Class B member is comprised of several individuals contributing sweat equity, but solely controlled by one individual acting as a trustee for the Class B member. That individual acting as trustee allocates those Class B interests at the start of the deal, and he or she reserves the right to reallocate those individual Class B interest at their discretion down the road.”

 

Thomas Castelli:

To be honest, I’m not 100% sure off the top of my head on that. I’d have to do a little research and poking around to get an answer to that.

 

Kim Lisa Taylor:

Yeah, I don’t think that’s a tax question. I think that’s more of a structuring question. Does your operating agreement allow you to do that or your trust agreement allow you to do that? And then, I think whatever distributions those Class B interest holders receive, regardless of whether it’s before or after you change it, they’re going to get taxed based on whatever distributions they actually received. It’s not like the IRS is going to read your trust agreement or your operating agreement. They don’t do that. They just take what face value or what’s stated on the K-1 and determine whether it’s ordinary income or long-term or short-term capital gain. So, I think that answers that question.

Rob asks, “Is it common for sponsor GPs to put catchup into their PPMs and deal structures?”

I will answer that, and I will say that I always advise that. If you want to know more about that, there’s an article on our website called “Class B Catchups Explained.” So, if you go into the syndicationattorneys.com Library, and then look out for the articles, there’s one called “Class B Catchups Explained.”

It goes through a scenario where you do take it or you don’t take it, and you’ll see that the returns that you end up getting are significantly different if you do than if you don’t. I’ve had some different clients run through that scenario both ways, and they’ve said that the change in ARR or average annual return to the Class A members is nominal, but the amount of money that the Class B members can earn is significantly more if you do the Class B catchup.

I’ve had too many clients that we used to structure them without that. We used to do just a preferred return to Class A and then a split. And I had several clients that said, “We will never do that again because the investors made all the money. We made nothing,” and they just said, “Unless we have a catch up, we’re just not going to do deals anymore.” So, they just only will do it that way. Any comments on that, Thomas?

 

Thomas Castelli:

No, I don’t have any comments on that.

 

Kim Lisa Taylor:

Barry asks, “Is depreciation and recapture tax typically shown in the PPM pro forma?”

 

Thomas Castelli:

Nice question. Honestly, no, it’s not. Not as far as I’m aware.

 

Kim Lisa Taylor:

And then, why not? I guess, do you just not know enough about it to know or…

 

Thomas Castelli:

Yeah, because you don’t know how long investors are going to hold the property for and that’s going to determine how much the depreciation recapture is. So, as far as I’m aware, it’s not in the pro forma.

 

Kim Lisa Taylor:

I guess there’s no reason you couldn’t put it in there if you could predict it with any kind of accuracy.

 

Thomas Castelli:

Yeah. And well, the problem is too you don’t know necessarily the exact value of the improvements that are going to go into the property, just the improvements like if you’re going to do value add, that’s going to be depreciated. I guess to your point, yeah, you could pro forma, but I generally don’t see that done. Right?

 

Kim Lisa Taylor:

Right. Yeah. And we usually tell our clients, you should do at least a five-year pro forma, and then we like to see that they imagine a sales scenario. And you have to make a bunch of assumptions about what’s the cap rate going to be at that time and what’s the NOI going to be, what’s the sales price going to be, all of that stuff. And by then, you would have an idea of what you’d spent in the early years on your capital improvements.

So sure, I think you could predict that. You just need to make sure that whenever you’re doing those kinds of predictive spreadsheets in your property information that you list all of the assumptions that you made, and then have a disclaimer that says that, “It’s possible that the assumptions we’ve made are wrong,” which would change this entire scenario.

So, the only real guarantee in real estate syndication is whatever you predict isn’t going to happen, it’s going to happen differently. And so, you need to make your investors aware that you’re just making some best guesses right now, but they shouldn’t be 100% reliant on that because things change.

And then somebody asks, “Will we get a recording of the webinar?” and that is yes. We will post this on our website.

 

Thomas Castelli:

I could probably take one more, Kim. Sorry, I could take one more question, but I have to hop off in a minute.

 

Kim Lisa Taylor:

OK, so we’ll go ahead and wrap up. So, Thomas, again, just give us your website.

 

Thomas Castelli:

It’s therealestatecpa.com.

 

Kim Lisa Taylor:

And ours is syndicationattorneys.com and investormarketingmaterials.com. So, we hope to have you guys all on a future broadcast with us. Also, if any of you are our clients, we are doing Friday Masterminds. If you’re not our client, you can become a client by engaging us through our pre-syndication retainer. We would love to have as many people as possible on these Masterminds, so everybody start working together to develop our investor marketing programs that will have all the investors you need ready and waiting for you when you have deals.

So, thank you again everybody for coming today and we look forward to seeing you next time. Thank you, Thomas.

 

Thomas Castelli:

Thank you again for having me.

 

Kim Lisa Taylor:

Bye-bye.

 

print