David McKelvey, partner, discusses operating agreements and the challenges that can arise. One of the primary issues in structuring operating agreements is the difference in breaking down the economic and tax books, according to David McKelvey, partner at Friedman Accountants and Advisors. In a typical deal, two partners come together to buy a building, both putting in money and splitting income 50-50% or perhaps 60-40%.
Things become complicated, however, if the situations shifts so that one partner is putting in capital while the other puts in “value” such as renovating the entire building—but no cash. “If you contribute something that has value, but not cash, there is no gain on your contributions so then the partnership has a carryover basis,” McKelvey explained.
McKelvey used a scenario where one partner buys a building for $1.5m. Several years later, the adjusted tax basis for that building is $1m after depreciation. At that point, the owner decides to renovate the building and carry over the adjusted tax basis of $1m into a new partnership. If the fair market value of the property is now $5m, the deferred value for the owner would be $4 million. If a renovation partner comes in and contributes $5m, the two become 50-50 partners on a $10m building.
“Our economic books would show a $5m property contribution and the $5m of cash to renovate—it would be $10m on the books. However, there are another set of books—tax books—that will look different,” McKelvey said. In the tax books, the capital accounts would show the $1m carryover and the $5m in cash, meaning the tax balance sheet would be $6m. Between the two books, there is a difference of $4m. So partners need to determine what book they will use for property depreciation purposes.
The way this property will depreciate over time affects the payout for each partner based on the books they use and the methodology behind it, McKelvey said. There are three methodologies: the traditional method, traditional with curative allocation and the remedial allocation, he added.
“If I’m the guy contributing the property, I want to make sure in our operating agreement it calls for the use of the traditional method, but if I’m the guy putting in cash, I want to use one of the other two,” McKelvey said. “The traditional method limits the amount of capital that can be shifted over to the ‘cash guy’ [after calculating the books and deprecation] whereas the other two create a [tax] vehicle where the full allocation can be shifted to make the ‘cash’ guy whole.”
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