The Department of the Treasury has released proposed regulations relating to the application of the fractions rule to real estate partnerships with qualified tax-exempt organizations. The proposed regulations are designed to allow real estate partnership allocations that are affected by certain common business practices to comply with the fractions rule.
- The proposed regulations would permit real estate partnerships to charge varying management and similar fees to their partners if such fees do not exceed two percent of the partner’s aggregate committed capital.
- Under current regulations, the allowance of allocations of a reasonable preferred return was subject to a requirement that the returns be currently distributed. The proposed regulations would eliminate the current distribution requirement, provided that the partnership agreement requires that such preferred returns be distributed before other distributions (except for tax distributions not to exceed the highest statutory federal, state and local tax rates applicable to that partner that are treated as advances against future distributions).
- The current regulations disregard allocations of partner-specific expenditures and unlikely losses for determining whether allocations violate the fractions rule, but are silent on allocations of income or gain to reverse those losses. The proposed regulations would allow such allocations to reverse unlikely losses or partner-specific items that were disregarded in computing overall partnership income or loss for purposes of the fractions rule.
- Current regulations require close scrutiny of changes in allocations that result from transfers or shifts of partnership interests. In order to accommodate common commercial staged closings, the proposed regulations provide that the IRS will not closely scrutinize changes in allocations resulting from staged closings within 18 months of the partnership formation if certain conditions are satisfied.
- The proposed regulations address concerns that remedies for a defaulting partner could result in allocations that do not comply with the fractions rule by excluding resulting shifts in interest from close scrutiny and disregarding allocations to partners to adjust their capital accounts as a result of unanticipated capital contribution defaults or reductions.
- In the context of tiered partnerships where tax avoidance is not a principal purpose of the structure, a lower-tier partnership can satisfy the fractions rule by demonstrating that the relevant chains satisfy the fractions rule. Under the current regulations, the “independent chain” approach for demonstrating fractions rule compliance examines the lower-tier chains independently if the upper-tier partnership allocates the items of each lower-tier partnership separately. The proposed regulations remove the requirement to separately allocate income from the lower-tier partnerships.
- The current regulations include a de minimis exception under which the fractions rule does not apply to the partnership if all qualified partners own de minimis interests in the partnership (not more than 5% in the aggregate) and taxable partners own substantial interests through which they participate on substantially the same terms as the qualified organizations. The proposed regulations provide a mirroring de minimis exception so that the fractions rule similarly does not apply to a partnership where all non-qualified organization partners own de minimis interests (not more than 5% in the aggregate), as long as the partnership’s allocations have substantial economic effect.
- The proposed regulations would also increase the de minimis exception for allocations of loss or deduction away from qualified organizations that are not motivated by tax avoidance. The existing regulations treat such allocations as de minimis where the total amount of loss or deduction allocated away from the qualified organization is less than 1% and $50,000. The proposed regulations retain the 1% cap but would increase the dollar cap from $50,000 to $1,000,000.
The Treasury Department and the IRS are considering comments on the proposed regulations and have also requested further comments on whether a “more likely than not” standard for determining when a loss or deduction is unlikely to occur and should therefore be disregarded in computing overall partnership income or loss for purposes of the fractions rule.
The proposed regulations may be applied by taxpayers for taxable years ending on or after the date of publication in the federal register (expected to be Nov. 23, 2016).
If you have any questions about the status or details of the proposed or current fractions rule regulations, please contact:
Lawrence J. Arem
Leila E. Vaughan
Keith W. Kaplan, Esq.
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