CPAs can use their
expertise to structure partnerships
between long-term community investors
and developers who want to contribute to
improving markets without displacing current
residents and local businesses.
For tax purposes, forming
an LLC may be the best approach to a
development partnership. The
partners generally benefit from reporting
their share of LLC taxable income on their
individual tax returns, avoiding the double
taxation of a C corporation.
An increase in equity
creates a win-win situation. In
this example the property owner converts his
equity to cash and retains title to his
business property. The developer takes
advantage of an improved loan-to-value ratio
to leverage her cash and secure project
An LLC may allow for more
flexible terms when negotiating the
details of community development partnerships.
It is unlikely that each member will
contribute an equal value of property or cash.
It’s important for the operating agreement to
comply with IRC section 704. This
substantiates that income allocations have
economic substance and are likely to be
accepted for tax purposes.
Curtis O. Sanders, CPA, is
the former CFO of Abyssinian Development
Corp., Harlem, N.Y. He can be reached at email@example.com
A major challenge of community development is
crafting a plan to revitalize neighborhoods without
displacing current residents and local businesses.
CPAs can use their expertise to help structure
partnerships between people with long-term investments
in their community and developers looking to invest in
the improving market conditions. This article uses a
hypothetical situation involving a businessman named
Mr. Smith to explore several tax and accounting issues
that can arise through such a partnership.
Smith owns a five-story, corner building on a prime
commercial boulevard. From the first floor of this
building, he operates a profitable business, Smith
Hardware. The top floors of the building, which was
originally a rooming house, have been vacant since he
purchased it. The cellar is used for storage. (It is
common for buildings in undervalued areas to be
underutilized in this manner). There are no mortgages
on the building, and Mr. Smith’s tax basis in the
property is zero. As a result of neighborhood
improvements, property values have increased
dramatically since Mr. Smith originally invested in
the property. He now wants to benefit from the
improved market conditions while continuing to operate
his hardware store.
Mr. Smith originally
considered selling the building to profit from the
economic turnaround, but he didn’t want to relocate
his business or be forced to negotiate a lease with
the new owner to remain at his current location. A
more viable alternative came about when he was
approached by Ms. Johnson, a community-oriented
developer who offered to convert the top floors into
condominiums, sell the units, and share the profits
with Mr. Smith on an equitable basis.
accomplish this, a single purpose limited liability
company (LLC) was formed (see “
The Choice-of-Entity Maze,” JofA, March
07, page 64). The LLC form was chosen over a C
corporation to avoid double-taxation issues later on.
The resulting company, Smith Development LLC (SDL),
has two members: Mr. Smith (who would contribute his
property to SDL) and Ms. Johnson (who would contribute
cash to cover the pre-development and soft cost of
development). Soft costs generally include
architectural, engineering, legal fees, financing fees
and other costs not directly associated with
construction of the project. Construction financing
would cover the cost directly associated with
renovating the units, often referred to as hard costs.
Once the condominium units are completed and sold, Mr.
Smith will receive the first floor and cellar as a
non-taxable liquidating distribution.
alternative allows Mr. Smith to convert equity in his
property to cash, to benefit from the development and
sale of the condominium units, and retain title to the
space he uses to operate his hardware store. Ms.
Johnson significantly improves her loan-to-value ratio
(the amount the bank will finance based on the
projected value of the completed project) by
partnering with someone who has clear title to the
property. Generally, the lower the loan-to-value
ratio, the easier it is to obtain financing. Since a
significant portion of the value of the completed
project is the result of the appreciated value of the
land, Ms. Johnson minimizes her cash investment.
The transfer of property from Mr. Smith to
SDL should be a tax-free event, under the
Internal Revenue Code (IRC). However, it may
be subject to state or local transfer taxes.
For book purposes, the fair market value of
the property will be credited to Mr. Smith’s
equity account. For tax purposes, Mr. Smith’s
basis in the property remains unchanged. The
difference between the property’s book basis
and tax basis results in a built-in gain that
will be recognized upon sale of the units.
IRC section 704(c) requires special
allocations to accommodate built-in gains. The
regulations provide for three methods of
making special allocations: the Traditional
Method; the Traditional Method with Curative
Allocations; and the Remedial Allocation
Method. The regulations also allow the use of
any other reasonable method as long as it is
section 707, if Mr. Smith receives a cash
distribution within two years of contributing
his property to SDL, this distribution would
be presumed to be part of a disguised sale.
However, this presumption can be overcome. The
underlying principle to guide the exchange of
Mr. Smith’s property for an equity interest in
SDL is that in substance, as well as form, Mr.
Smith’s equity in SDL is subject to the
entrepreneurial risks of entity operations.
This will mitigate the risk of the transaction
being designated as a disguised sale.
Several factors are considered when
determining if an LLC member is subject to
entrepreneurial risk. Some of these factors
include the timing and amount of the
distribution, a member’s legal right to
receive a distribution, how the distribution
is funded, and the liquidity of the business.
The type and amount of liabilities assumed by
the LLC are also factors in determining if a
disguised sale has occurred. It is possible
that the transaction could be reclassified as
a sale or partial sale if in substance the
transaction is deemed to be a sale
profits may be divided in a manner that does
not correspond to the percentage of equity
contributed at fair market value. Accordingly,
a CPA should review SDL’s operating agreement
to ensure that provisions regarding compliance
with IRC section 704 are included. The three
primary provisions of IRC section 704 that
should be incorporated in the operating
Proper maintenance of capital
Liquidating distributions made in
accordance with the positive capital balances
of the partners.
Partners with negative balances
in their capital accounts will be subject to
qualified income offset.
provisions substantiate that income
allocations have substantial economic effect
and are likely to be accepted for tax
Mr. Smith’s equity account
will be credited for the full fair market
value of the property contributed. However,
the first floor and the basement will be
returned to Mr. Smith as a liquidating
distribution, and the upper floors will be
developed and sold as condominium units. The
value of the property that will eventually be
returned to Mr. Smith should be classified as
“Held for Use.” The value of the property that
will be allocated to the cost of the
condominiums should be classified as “Held for
Adding numerical data to the hypothetical case
illustrates how the project would be funded and how
cash derived from projected profits would be
The value of the property
contributed by Mr. Smith should be determined by a
qualified real estate appraiser when it is
contributed. The AICPA Audit and Accounting guide
Use of Real Estate Appraisal Information is
an excellent resource for selecting and instructing
New Valuation Standard
AICPA members should be aware of AICPA
Statement on Standards for Valuation Services
no. 1, Valuation of a Business, Business
Ownership Interest, Security, or Intangible
Asset (SSVS1). Paragraph 6 of that
statement says SSVS1 does not apply when the
subject of the valuation is provided by the
client or a third party (such as a real estate
appraiser) and the CPA does not apply
valuation approaches and methods. SSVS1 would
not apply in this example, assuming the CPA is
not estimating the value of Smith Development
LLC or its equity. As a practical matter, the
CPA should have a clear understanding of the
services being provided.
A real estate appraiser estimates the fair
market value of Mr. Smith’s property at $1.6 million.
Of this amount, $1 million is allocated to property
“Held for Sale” and $600,000 is allocated to property
“Held for Use” (see sidebar “Tax Considerations”). The
building does not have a mortgage. The project manager
determines that 12 condominium units can be developed
at a total hard cost of $1,837,500, to be financed by
a construction loan (the total includes interest
expense). The estimated soft cost of $367,500 is to be
funded by the developer. Thus, the total cost to
develop the property is $3,205,000. The projected
sales price for each unit is $450,000 for total
projected revenue of $5.4 million. Mr. Smith and Ms.
Johnson agree to share the profits equally. The
sources and uses of funds for the transaction are
presented in Exhibit 1.
SDL’s Statement of Position before
construction financing illustrates how equity
contributed by each partner is reflected on its
Source & Use of Funds (see Exhibit 2). SDL’s
Statement of Position after the units are completed
illustrates that the equity and financing have been
used to complete development of the condominium units
(see Exhibit 3). SDL’s Statement of Position after the
sale of the condominiums is presented in Exhibit 4.
The $5,184,000 cash shown in Exhibit 4 reflects the
projected sales cost of the 12 condominiums minus
sales costs of 4% or $216,000.
By partnering with a community-oriented,
for-profit developer, Mr. Smith has the potential of
earning more than the estimated $1.6 million FMV of
his property (see exhibits 5 and 6). In
addition, he will be able to retain title to the
commercial space of the property that he develops. Mr.
Smith has the option of selling or renting his
commercial space in the future.
In real estate deals everything is negotiable.
In this case, the developer (Ms. Johnson) would assume
the financial risk of all pre-development and soft
costs in exchange for 50% of the profits and a
developer’s fee. The transfer of title from Mr. Smith
to SDL would occur contemporaneously at the loan
closing for construction financing. Mr. Smith could
focus on operating his hardware store knowing that his
partner has a financial interest in completing the
project in a timely and profitable manner. Depending
on the facts of the particular deal, the profit
distribution percentages may vary. Some deals will
require a cash payment from the developer to the
property owner. If the property has an existing
mortgage, this will also affect how a deal would be
Accounting for Impairment
FASB Statement no. 144, Accounting
for Impairment or Disposal of Long-Lived
Assets, provides guidance on the
impairment of real estate assets for financial
reporting purposes. While a project is being
developed, its carrying amount is equal to its
cost, as long as that amount is not greater
than the expected future cash flows of the
If the project
incurs an impairment loss while under
development, the impairment would be recorded
as a write-down, which reduces the carrying
amount of the assets and establishes a new
cost basis for the asset. Restoration of
previously recognized impairment losses is
After the project is
completed, an impairment loss against assets
designated as held for sale would be recorded
as an allowance against the net carrying
amount of the asset. Subsequent increases in
fair value may reduce the allowance; however,
the allowance cannot be reduced below zero. An
impairment loss against the assets designated
as held for use would be reflected as a
In both cases the
impairment losses should be reported as part
of income from continuing operations before
Another scenario for which this type of deal may
be appropriate is one in which a longtime resident
owns property in an area that is developing
condominiums. The homeowner would partner with a
community developer to develop condominiums, then
share in the profits of the condominium sales and
receive one of the units as a liquidating
corporations in conjunction with state, local and
federal agencies are doing an outstanding job in
developing and revitalizing underserved communities.
Major for-profit entities will invest in underserved
communities once they are confident the area is in
transition. CPAs serving clients in underserved
communities can help them take advantage of new
opportunities as their neighborhoods improve.
Adviser’s Guide to the Tax Consequences of
the Purchase and Sale of a Business, Second
Edition , William Olson, CPA, Ph.D.
Taxation of LLCs, LLPs, LPs
and Other Partnerships , a CPE
self-study course (#731706)
LLC and Partnership Taxation:
Beyond the Basics , a CPE self-study
Advanced Planning for LLC
& Partnership Transactions , a CPE
self-study course (#731536)
information or to place an order, go to www.cpa2biz.com
or call the Institute at 888-777-7077.