Forming Real Estate Joint Ventures Tax Issues Checklist
This checklist provides an overview of tax implications pertaining to the formation, operation, and ultimate unwinding of a real estate joint venture and ongoing tax issues that can affect parties to the deal. Checklist guidance pertains to tax considerations relevant to choosing a real estate joint venture entity and tax issues of importance at each stage of the joint venture's life cycle.
A joint venture is a commercial collaboration in which two or more unrelated parties pool, exchange, or integrate some of their resources with a view to mutual gain, while they simultaneously maintain a certain level of independence in other areas. There are no specific tax laws, or other laws, governing joint ventures, and "joint venture" has no technical legal meaning as a term of art. This checklist outlines some common tax issues relevant to planning and executing a real estate joint venture arrangement.
For more information on joint ventures, see Joint Venture Structuring and Planning, Key Provisions in Joint Venture Agreements, Real Estate Joint Ventures, and Joint Ventures in International Jurisdictions.
Establish the Real Estate Joint Venture Entity
Consider potential liabilities that can affect real estate joint venture agreement principals. Plan for, and define, these fundamental building blocks:
• The joint venture's business mission and strategy to achieve defined goals
• The joint venture's merits as a formal or informal alliance of like-minded parties (This threshold definition is critical to resolution of potential tax and other problems, or to dissolution pursuant to such problems.)
• Patents, trademarks, or other intangible assets that may be derived from joint venture pursuits
• The joint venture's life span, ending on a date certain, or surviving for an indefinite time period
• Financial, intellectual, goodwill, tangible property, and other assets contributed by joint venture principals
• Compatibility of joint venture principals in establishing and executing the joint venture mission
• Joint venture voting and decision-making dynamics tied to authority and obligations of each principal
• Joint venture responsibilities assigned to each principal
• The joint venture's potential influence on the business profile and reputation of each principal
• Agreement on the abilities of all principals to meet capital calls, personal guarantees, and other responsibilities, as they emerge
Ensure Agreement and Compatibility of Principals
Sequentially follow these parameters to conceive and create a viable joint venture agreement document:
• Examine objective and subjective character factors of each prospective business partner to discern the likelihood of amicable relationships between all principals.
• Analyze the business plan's prospective merits and drawbacks to define its potential success or failure.
• Learn each principal's vision for the joint venture engagement, its potential benefits, and potential hazards.
• Understand outlook for each principal's financial and other responsibilities in the creation, development, going concern operations, and wind down of the joint venture.
• Recognize differences and negotiate points of disagreement to resolution.
• Be mindful of both tax-centric and other factors, in considering financing options, such as preferred and common equity; capital contributions and equity-based joint venture arrangements; and/or standard or mezzanine debt, where debt is employed.
• As appropriate, consider potential benefits of incentive allocations.
• Based on the foregoing, prepare a detailed joint venture strategy and business plan with your potential partners, analyzing anticipated problems and projected resolutions to the extent possible and scheduling annual or semiannual plan updates.
Leverage Tax Implications in Joint Venture Entity Choice
Evaluate facts and circumstances tied to your real estate joint venture to determine if a C corporation, S corporation, limited liability company, or partnership makes sense for the joint venture, or if the interests of the joint venture parties are best advanced by a strictly contractual relationship. Consider these elements:
• The joint venture can be taxed as a corporation or as a partnership.
• C corporation and their shareholders are both subject to tax obligations; whereas flow-through entity principals are not.
• Partnerships and other flow-through entities offer greater flexibility than corporations with respect to the allocation of gains and losses.
• Principals might not want to report income on their own tax returns, preferring corporate tax treatment to flow-through entity taxation.
Plan for Tax Effects throughout the Real Estate Joint Venture Life Cycle
Assess which type of entity is best suited for your situation and the tax impact of each event in the going concern segment of your real estate joint venture's life cycle.
Establish a contractual real estate joint venture to eliminate tax issues by retaining the existing assets ownership of participating principals. Alternatively, deploy a corporate or partnership entity as a joint venture vehicle, transferring assets to the entity subject to applicable gain-recognition rules. Consider tax-centric and other issues relevant to assets contributed by each principal such as:
• Inventory tangible assets, if any, that joint venture principals contribute and account for which assets are newly acquired and which they have been previously used in a trade or business
• Account for depreciation deductions previously claimed on contributed assets and project tax consequences of depreciation recapture upon resale by the joint venture (In general, gains on depreciated business assets that are sold constitute ordinary income for federal tax purposes.)
• Inventory intangible assets contributed by joint venture principals
• Determine start-up costs and how joint venture principals will share them
• Establish each joint venture principal's economic interest and authority in business operations, recognizing distinctions between the active or passive status of each as decision-makers and/or investors
• Follow jurisdictional legal form filing and fee payment requirements (See I.R.C. §§ 195, 351, 721, 1245, 1250.)
For more information on this topic, see Tax Planning for Partners, Partnerships and LLCs § 14.06.
Plan for tax issues arising during the life of the joint venture which turn largely on the type of entity involved including:
• Recognize and report corporate entity income and expenses, separately and apart from joint venture principals. Joint venture distributions of profits and rights to joint venture ownership shares are economic benefits (or losses) that inure to principals. I.R.C. §§ 704, 70.
• For partnerships, determine if you will follow I.R.C. Subchapter K:
○ Evaluate specific income and expense allocations to suit joint venture principals' needs and circumstances.
○ Do not apply Subchapter K if the joint venture entails only investment purposes and does not engage in an active business; or, under other limited conditions. I.R.C. § 761(a).
• For contractual joint venture arrangements, recognize each principal's income and expenses arising from their respective shares of joint venture business.
For more information on this topic, see Tax Planning for Partners, Partnerships, and LLCs § 4.01.
Consider Project Termination Scenarios
Plan exit strategies to account for joint venture principals' interests and memorialize mutually agreeable exit options. Plan for contingencies, such as failure of operational purpose, or disputes regarding division of assets pursuant to business terminations on short notice. Review the following entity appropriate exit scenarios:
• Contractual joint ventures. Minimal tax consequences accompanying exits from these arrangements typically call only for an accounting of profits or losses business and winding up contractual obligations.
• Corporations. The viability of an exit from a corporate joint venture turns largely on the liquidity of common stock in a common stock sale or in the sale of the joint venture to one or more third parties.
• Partnerships. Choose to use a partnership vehicle to facilitate flexible liquidation timing and terms, considering these elements:
○ In the joint venture agreement, specify events that will dissolve the partnership.
○ Avoid constructive terminations from transactions that exchange more than 50% of partnership interests.
○ Be mindful of tax reporting details that can emanate from partnership tax years that deviate from tax years of individual partners. See I.R.C. §§ 311, 331, 355, 361, 708, 731, 751.
For more information on this topic, see Tax Planning for Corporations and Shareholders §§ 9.04, 11.02; Tax Planning for Partners, Partnerships, and LLCs § 8.01; and Business Organizations with Tax Planning, Chapter 29.
Apply Tax Factors Specific to Joint Venture Partnerships and LLCs
In forming the joint venture, consider tax benefits and potential hazards applicable to partnerships and limited liability companies (LLCs).
Utilize Accounting and Election Features
Consider the following actions applicable to distinctive tax benefit assets:
• Accounting segregation from individual real estate joint venture principals
• Allocate items of income, gain, loss, deduction, and credit, according to each principal's distributive share by doing the following:
○ Draft allocation provisions following I.R.C. § 704 and I.R.C. § 706 standards.
○ Verify the substantial economic effect of allocations. See Treas. Reg. § 1.704-1(b)(2).
• Entity's taxable year distinct from taxable year of principals
• Entity elections affecting amount and timing of income and deductions
○ See I.R.C. §§ 705, 722, 733, 742; see also I.R.C. § 707(a), (c).
• For married couples materially participating in a real estate joint venture, assume "qualified joint venture" status, following I.R.C. § 761(f)
Satisfy Economic Effect Test
Verify compliance with the following economic effect tests:
• Economic effect test. Evaluate how the entity maintains capital accounts, measuring each partner's equity in the partnership. In general, this safe harbor requires these partnership agreement provisions: Verify that allocations are "substantial," and that they are justifiable "independent of tax consequences." See Treas. Reg. § 1.704-1(b)(2)(iii).
• Alternate economic effect test. Include a "qualified income offset" provisions. Avoid increasing a deficit balance in a partner's capital account that exceeds the partner's obligation to restore the deficit. See Treas. Reg. § 1.704-1(b)(2)(ii)(d); see also Treas. Reg. § 1.704-1(b)(2)(ii)(d)(3) and Treas. Reg. § 1.704-1(b)(2)(iii).
• Economic equivalence test. Ensure that deemed liquidation in each year of the partnership's existence yields the same economic results as if the economic effect test had been met. See Treas. Reg. § 1.704-1(b)(2)(ii)(i). See also Treas. Reg. § 1.704-1(b)(2)(iii).
See Treas. Reg. § 1.704-1(b)(2); see also Treas. Reg. § 1.704-1(b).
Contribute and Distribute Property Tax-Free
To the extent possible, you will want partner contributions property to a partnership and any distributions to occur without recognizing gain or loss. See I.R.C. § 721(a); see also I.R.C. § 722. To do this, you will need to be sure to:
• Execute cash and property distributions that do not exceed a partner's or member's outside basis in its interest in the entity to avoid a taxable event
• For property contributions with built-in gains or losses, defer property distributions for seven years to avoid the partner's recognition of gain or loss (See I.R.C. § 731(a). See also I.R.C. §§ 704(c)(1)(B), 737, 707(a)(2), 705, 732(a), 733.)
• Be mindful of applicable exceptions (See I.R.C. §§ 83, 707(a), 721(b), 752(b).)
Deduct losses flowing through to the member or partner to the extent that they do not exceed basis in the entity:
• Be mindful that a real estate partnership's substantial reliance on large amounts of borrowed funds increase the partner's basis by its share of the partnership's liabilities, even with nonrecourse debt.
• Charge-back may apply to the partner's expanded share of allowable losses when the debt is repaid or when the property is sold. Ensure the partner's ability to use the loss deductions generated. See I.R.C. §§ 722, 752, 465, 469.
Avoid Disguised Sale and Exchange Traps
Avoid the appearance of a disguised sale that abuses favorable tax treatment. Consider the potential scrutiny of nonrecognition of gains or losses pursuant to contributions and distributions if transactions involve:
• A partner's nonrecognition of gain after receiving a cash contribution immediately following the partner's contribution of appreciated property to the partnership which, in effect, is a sale of appreciated property to the partnership
• A distribution of cash to a partner two years after his or her contribution of appreciated property to the partnership (See Treas. Reg. § 1.707-3(c)(1); see also Treas. Reg. §§ 1.707-3(d), 1.707-4.)
• A partner's direct or indirect contribution of property to a partnership, followed by the partner's enrichment via a related direct or indirect allocation and distribution of partnership income (See I.R.C. § 707(a)(2)(A).)
• A partner's direct or indirect contribution of money or other property to a partnership, accompanied by the partnership's direct or indirect related distribution of money or other property to the same or another partner (See I.R.C. § 707(a)(2)(B).)
Apply Capital Account Principles
To comply with the economic effect test, include partnership maintenance of partners' capital accounts in the agreement document, in compliance with regulations. Treas. Reg. § 1.704-1(b)(2)(ii)(b)(1). Recognize the following increases in partners' capital accounts:
• Cash that the partner contributes to the partnership
• Fair market value of noncash property contributed (less liabilities encumbering the property)
• Partner's share of partnership liabilities assumed by the partner
• Partner's distributive shares of partnership income and gain, including tax-exempt income
See Treas. Reg. § 1.704-1(b)(2)(iv)(b).
Recognize the following reductions in partners' capital accounts:
• Cash distributed by the partnership to the partner
• Fair market value of partnership noncash property distributed to the partner (less liabilities encumbering the property)
• Reduced partner's share of partnership liabilities
• Partner's distributive share of partnership loss and separately stated items of loss and deduction
• Partner's distributive share of partnership expenditures that are not deductible or cannot be capitalized
See Treas. Reg. § 1.704-1(b)(2)(iv)(b).
Heed Partnership Audit Rules
Include the following provisions in joint venture partnership governing documents:
• Tax indemnification in the partnership agreement, in any partnership share purchase agreement, and to the extent possible, from other partners
• Election-out provisions for partnerships that furnish no more than 100 Schedules K-1 to the partners (See I.R.C. § 6221(b)(1)(A)–(E).)
• Election-out provisions for partnerships that provide an adjustment statement to each partner in the reviewed year (An adjusted statement is similar to a Schedule K-1.)
• Allocation of imputed underpayments according to each partner's interests in the reviewed year
See I.R.C. § 6221(a), (a)(1), (d).
Consider State Tax Implications in Joint Venture Entity Selection
As appropriate to state tax regimes affecting the joint venture, apply adjustments to federal taxable income, including:
• Add-backs of certain expenses (e.g., related party interest and intangible expenses)
• Depreciation deduction adjustments
• Reclassification of character of certain gross income items