These collaborations can breathe life into troubled properties.
Despite the doom and gloom in today’s news, companies and individuals with cash are willing to invest in high-value properties that currently are underperforming. By using a joint venture partner to commit additional capital to a property, owners can pay down financing to a functional level or make necessary capital improvements. While sometimes risky, if well executed these arrangements also may attract high-quality tenants while raising a property’s value.
Vet Your Partner
The most important consideration when working with a JV partner is to do your homework. Though cash is king in the current market, don’t let funding blur the details. It is imperative to completely understand a deal’s economics and effects.
Many of today’s JV partners are looking for protection and greater upside. Some are trying to structure deals that are similar to loans. Be wary of a JV partner that seeks a 15 percent priority return on contributed capital plus the return of its capital first, which essentially is a 15 percent nonrecourse mortgage. The numbers can be startling. With $10 million of contributed capital and a 15 percent preferred return, the required preferred return would be $1.5 million annually, which ignores the compounding of the preferred return.
In addition to hammering out the economic relationship, both JV partners must agree on who controls the property and share a synergistic outlook on the property’s exit strategy. For instance, if one party considers the property to be a long-tem hold, the other should not be looking to flip the property quickly.
Property owners must address many tax concerns when adding a partner, and the place to do that is in the JV agreement. With careful planning, owners can minimize the tax ramifications of restructuring.
When negotiating a JV agreement, taxpayers must consider issues such as income allocations, Internal Revenue Code 704(c) depreciation allocation methods, and lock-out periods on the property’s sale and debt repayment. JV agreements should be drafted carefully to avoid situations that cause phantom income allocations, which are income allocations without cash. This can be accomplished by carefully modeling the allocations or including tax distribution clauses.
The most advantageous IRC 704(c) method also should he determined. The original property owner must be aware that depreciation deductions may be stripped and sent to the JV partner. With proactive tax planning, the burden of the stripped deductions can be reduced.
Lastly, negotiating lock-out periods where the property can’t be sold or the debt can’t be paid down can lead to many tax benefits. These include holding off gain recognition upon sale to a more tax advantageous period and avoiding the recapture of large negative capital accounts as a result of a decrease in the debt that supports them.
As with all property-related decisions, owners should seek the advice of tax and legal specialists before embarking on JV partnerships.
–by Jonathan Farrell, CPA, a principal in the tax department of DiCicco, Gulman & Co. LLP, a Woburn, Mass. – based business advisory firm.