Partner puzzles: Sec. 470's broad applicability may surprise practitioners.

The American Jobs Creation Act of 2004 created Internal Revenue Code Sec. 470 to deal with perceived abuses from Sales-in Leased-out, or SILO, transactions. These transactions were created to shift tax benefits to taxable entities and shift reportable income to tax-exempt entities.

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The law was to take effect for all years beginning in 2004.

When the act was signed and I first looked into this new section, I found it confusing and thought it had little relevance to my clients. After all, I don't assist clients with creating tax shelters, and I don't deal with tax-exempt entities.

Soon after the law was enacted, the provisions of IRC Sec. 470 were postponed for a year and I, again, put off study. I had a reprieve for 2005 as the law was again postponed.

But the section was not repealed or postponed this year, and as of this writing, IRC Sec. 470 is the law and in effect for calendar year 2006.

Take Note of Sec. 470's Broad Applicability

This law may surprise many practitioners in its broad applicability as it affects legitimate, common transactions in some very powerful ways.

Any time a pass-through entity has a tax-exempt partner--which includes IRAs, Roth IRAs, pension plans, foundations or charities (entities that file Form 990)--the deductibility of losses by the non tax-exempt entities will likely be reduced with rules similar to the passive loss limitations. This also can be true if a lessee (tenant in a building) is a not-for-profit entity.

Another challenge for practitioners navigating the new law is that Secs. 1031 and 1033 are not available for common transactions that fall under Sec. 470. So, commercial real estate with a not-for-profit tenant may not be able to be exchanged or an exchange may be blown if a not-for-profit tenant is in the acquired property.

Safe Harbor 

Now that I have your attention, there are safe harbors in the law that can be used to weave your way through this mine field.

However, a potential difficulty facing practitioners is that these safe harbors don't address common entity structures and common lease transactions that many of our clients routinely hold.

Where it once was rare to have partnerships and LLCs with IRA partners, it is now common, at least in the partnerships and LLCs I prepare.

In short, if a partnership is a partner in another partnership, you have to look through to determine if there is a problem throughout the entire chain of entities.

Sec. 470 Cross References to Sec. 168(h)

Sec. 470 cross references to Sec. 168(h), which provides for qualified allocations of income, deductions, credits and partner basis.

To be "qualified," the allocation must be pro rata and not vary in application. This sounds reasonable until you consider that many real estate partnerships have "preferred returns," "carried interest" and "incentive allocations" to provide developers' returns, and investors a feeling of security for their contributions to the entity.

Sec. 168(h)(1)(A) refers to tax-exempt use property to mean that portion of any tangible property (other than non residential real property) leased to a tax-exempt entity.

Sec. 168(h)(1)(B)(i) refers to nonresidential property leased to a tax-exempt entity in a "disqualified lease." Sec. 168(h)(1)(B)(ii) defines a "disqualified lease" as any lease to a tax-exempt entity if one of the following conditions are met:

1) The property was financed by tax-exempt debt;

2) The lease contains a fixed or determinable purchase or sale option;

3) The lease term exceeds 20 years; or

4) The property is subject to a sale lease back arrangement.

If you have an entity that has tax-exempt partners, then the property is considered tax-exempt use property. Or, if you lease to a tax-exempt entity and the above conditions apply, then special rules in Sec. 470(d) will not allow the application of the tax deferred exchange rules under Secs. 1031 or 1033.

Also, if the acquired property in the exchange falls under the limitations of secs. 168(h)(1)(B) or 168(h)(1)(A), then the exchange will fail.

Another special rule is that if property was formerly tax-exempt use property, then any deduction with respect to the property will be allowed only to the extent that there is net income from the property for that year.

Conclusion

Practitioners must be aware of IRC 470, primarily for real estate investments by individuals and pass-through entities that have a relationship with a not-for-profit entity as investors or as lessees. A thorough knowledge of this section, along with related sections of the code, will be necessary to work in this practice area.

But since Sec. 470 has the potential to burden or surprise taxpayers, further regulations or repeal may yet occur.

For more information on the code, I recommend an article in the August 2005 Journal of Taxation by Richard M. Lipton, which provides citations and examples of how the law will work.

By George Paulsen, CPA 

George Paulsen, CPA is a partner at San Francisco-based Hood & Strong LLP and a member of CalCPA's Committee on Taxation. You can reach him at [e-mail].