How to opt out of the new partnership audit rules
Anita Wescott, CPA
Many real estate businesses are formed as partnerships. Beginning this year, the IRS is applying new procedures to its partnership audits. Under the procedures, any adjustments and penalties after an audit generally will be assessed against the partnership itself, rather than against individual partners. However, certain partnerships can opt out, and the IRS has issued final regulations that explain the details of this procedure.
The new audit procedures implement the Bipartisan Budget Act of 2015 (BBA). That law repealed the audit procedures outlined in the Tax Equity and Fiscal Responsibility Act and its exception for electing large partnerships.
Partnerships with 100 or fewer qualifying partners can opt out of the BBA’s procedures, meaning they and their partners would be audited under the rules applicable to individual taxpayers. Qualifying partners are limited to individuals, C corporations, foreign entities that would be treated as C corporations if they were domestic, S corporations and deceased partners’ estates.
According to the regulations, eligible partnerships must furnish 100 or fewer Schedules K-1. Spouses count as two partners. Special rules apply when determining the number of partners if a partner is an S corporation. Persons who hold a partnership interest on behalf of another person are not considered eligible partners.
Eligible partnerships must make the opt-out election on their filed tax returns, including extensions, for the tax year to which the election applies. Once made, an election cannot be revoked without IRS consent. Partnerships must notify their partners of the election within 30 days of making it. The notification can be made in the form and manner the partnership chooses.
The election must include each partner’s name, tax identification number and federal tax classification. It also must include an affirmative statement that the partner is an eligible partner, as well as any additional information the IRS requires in forms, instructions or other guidance.
If the IRS determines that an election is invalid, it will notify the partnership in writing. In such a case, the new partnership audit procedures will apply and adjustments and penalties will be collected at the partnership level.
The final regulations for opting out of the new partnership audit regime apply to tax years beginning after December 31, 2017 — the same effective date as the audit rules. Consult with your ORBA advisor to determine whether your partnership should consider making the election.
What you need to know about construction loans
Adam Levine, CPA, CFP®
Not all loans and loan processes are the same. Securing commercial real estate loans is different from securing construction loans. If you are seeking a construction loan, here is some information to help you understand the lender’s mindset.
Securing unfinished collateral
While lenders secure regular commercial loans with existing cash flow, they secure construction loans with unfinished collateral. The collateral’s value depends on the appraised land value, the project’s completion and its estimated economic viability. It is natural for lenders to seek assurances that a developer will manage construction risk from the project’s start. They also want to ensure that developers have enough money invested in the venture to overcome construction problems and complete the project successfully.
In a tight credit market, lenders evaluating construction loan applications consider the project’s loan-to-value (LTV) ratio. This is calculated by dividing the loan amount by an appraiser’s projection of the fair market value of the completed and occupied project, multiplied by 100%. Conventional lenders look for an LTV that is not higher than 75% to 80%.
Lenders also want to know the project’s loan-to-cost (LTC) ratio. This is the loan amount divided by the total project cost from the time of acquisition to project completion. Because lenders are often wary of pre-construction appraisals, they may look to the LTC in their underwriting evaluation.
Predevelopment project costs include all expenses before construction, such as architectural, engineering, survey, legal and permit work. They can also include land acquisition and demolition costs. Development costs encompass expenses from site preparation through construction, including materials, labor, insurance and taxes.
Traditionally, lenders require developers to have at least 20% equity in the project, which can take the form of free-and-clear land. In some situations, lenders may require higher contributions from developers — and they may want personal guarantees as well.
Calculating the numbers
Lenders also scrutinize the project’s debt-service-coverage ratio. This involves calculating net operating income for the completed project in order to determine if it is sized appropriately for proposed loan payments. Typically, the debt-service-coverage ratio will be higher for single tenancy, single use properties and multi-tenant commercial properties.
Your lender will also look at your net-worth-to-loan-size ratio. Your net worth should be at least as large as the loan amount. Be prepared to provide lenders with information explaining where pre-construction money was spent and the sources for those funds.
Lenders look for red flags when sizing up a project. For example, is land value based on its purchase price or its current market value? If you list the land value as higher than the purchase price due to improvements, expect lenders to question that claim. A higher value may be justifiable, if the developer assembled several parcels to form the development site, but it will not be justified for costs incurred while demolishing an existing building.
Completing the details
Lenders may require various conditions and provisions in both the construction and loan documentation to ensure that the project is constructed well, within budget and on time. This includes contract time provisions, use of the property, detailed costs, and caps on change orders and cost overruns. For larger projects, some lenders will require periodic site visits by an independent engineer or accounting professional to ensure that the project is progressing as planned and the percentage of costs incurred agrees with the project’s percentage of completion.
Finding the right loan
Remember, lenders also will review your track record — both in the market area and with the type of project being developed, as well as with the financial institution. As with all major decisions, contact your attorney and CPA to review your paperwork before signing.