Am I the crazy one? Or do other CPA’s just blindly allocate depreciation to GP’s?

Question

I have seen so many instances of GP’s receiving substantial allocations of depreciation on their K-1 without having contributed capital.

To me, allocating $1M of depreciation losses to a pool of co-GP’s when they are only on the hook to loose their $100k in cash contributions if the deal goes south goes against the most fundamental partnership tax law.

Even if its agreed on in the LLC agreement and all the other investors are willing to give up their depreciation, I don't see how that is actually substantiated by tax law.

It all comes back to Treasury. Reg. 1.704-1(b)(2).

Substantial Economic Effect.

It is as clear now as it was 25 years ago. Happy to share

a little bit right out of the partnership taxation textbook for all those curious enough to learn more about the nuance of allocating depreciation to GP partners.

To sum the law up as simply as I possibly can - tax losses must be allocated in a manner such that if those losses materialized and became actual losses of cash, the economic loss would match the tax loss. Therefore, if you are a GP with a $100k co-invest, you likely can't receive more than $100k of losses in most cases since your LPs would bear the burden of the remaining losses (and therefore receive the tax loss allocation).

Remember, just because your OA says it and your attorney gave it the green light, doesn’t mean that your tax return will reflect it.

Make sure your CPA knows this stuff.

Brian Burke · Answer

I’ll never understand why sponsors do this. I’ve always allocated all depreciation to the investors, and to me as the sponsor only pro-rata to my co-invest.  Then I see sponsors bragging on social media about how they pay no taxes because they get all this depreciation even when they have no capital in the deal.  Makes no sense.

Dylan Brown · Answer

@Evan Polaski time and time again I have sat across the table from those attorneys you were describing in your post and heard a similar argument about substantiating losses via loan guarantee.

However, without fail, every time I have asked those attorneys for clarification on their support for such a legal position, they have come up empty-handed.

I have been searching for the better part of two years for an attorney who can clearly articulate how it is they are substantiating such loss allocations. I have even grilled my own real estate attorney and paid his hourly rate just to see if I could get something out of him that I could bring back and use for my clients.

At the end of the day I have found that there is no way to substantiate such allocations based merely off of a guarantee of debt unless one or more parties enters into a deficit restoration obligation.

because so many investors and developers are risk-averse, a deficit restoration obligation is often times too much risk for them to take on an exchange for some depreciation, however, I still have numerous clients who are willing to take on that risk. This is very nuanced, and ultimately most people who I see taking such depreciation losses have not even thought through this far and are just doing it based on the guarantee itself.

I was so intrigued with this that I published a memo that points out the flaws in the logic of the attorneys that made the argument that a loan guarantee is sufficient to substantiate outsized depreciation allocations to sponsors who guarantee debt but put up less actual capital.

www.dylanbrowncpa.com/guarantees.pdf

Aaron Zimmerman · Answer

Thank you for sharing!

Dylan Brown · Answer

@Michael Murphy - I have tried in every instance and they have never done it.

my guess is that they draft the OA under false understanding and then when they dig into it they realize their error.

JD Martin · Answer

I think the rub is that you can do anything you want, by and large, until you are audited, and even then worst case scenario is the denial of the loss. The reward is large and the risk small. Reasonable attorney fees and a reversal of the deduction is not enough stick to avoid the practice in the first place. Imagine in an environment like today how much those tax losses might be worth.

Dylan Brown · Answer

@Evan Polaski I will offer a $1,000 bounty for the first attorney that can substantiate losses like you have described!! I would love to be able to finally tell my clients we have found the golden ticket we have been searching for.

Michael Murphy · Answer

Why don't you just require the law firm to issue a Legal Opinion on the tax treatment?

Evan Polaski · Answer

@Dylan Brown, while I don't know the tax code and laws, I will chime in that I know of several prominent syndicators that allocate losses in a manner similar to their carry, i.e. 70/30 carry on profits also equates to 30% right to depreciation losses.  And while I am not privy to the discussions with legal counsel, I have seen this type of structure outlined in sub docs that are prepared by large, marble floor law firms.  Presumably, but maybe this is my own naiveté, these same groups have their tax attorneys reviewing and opining on the policy prior to issuing docs.

From the GP perspective, I would argue that there are cash losses possible beyond their co-invest, specifically a loan default that triggers personal guarantees back to the GPs.

But more practically, I view this as another lack of alignment of interest (or at least the optics thereof).  This outsized weighting of depreciation losses CAN create another incentive for a GP to buy an okay deal versus a great deal. I mean, how else are they going to keep all of that 3% acquisition fee, if they can't also take a lot of depreciation to offset it?

Dylan Brown · Answer

Glad I am not the only one seeing this!There are a few instances (especially back in 100% bonus days) where I saw properties pumping out more tax losses than dollars invested and then there was additional losses left over for the GPs who guaranteed the debt, but besides that I think every other instance of GPs getting tax losses is essentially a sham (unless there is a DRO).

Am I the crazy one? Or do other CPA’s just blindly allocate depreciation to GP’s?

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