From time to time, we field questions from our investment partners regarding the classification of distributions received. The information presented below attempts to add some clarity to the topic.
Many closed-end real estate funds, structured as a pass-through entity such as a limited liability company (LLC) or limited liability partnership (LLP), pay regular monthly or quarterly distributions. These distributions are usually paid from cash flow from operations earned on the assets owned by the entity. Distributions can also come from non-operating sources as well, such as a sale or refinance of an asset. Distributions made following a sale of an asset are commonly referred to as “liquidating distributions,” and those derived from a refinance are most commonly referred to as “debt-financed distributions.”
Real estate investors expect to earn a return on their capital from either the operating profits of the partnership and/or the profits from the sale of an asset within the partnership. Those distributions derived from the operating profits are most commonly referred to in financial reporting as Return on Capital.
Asset sales and refinances are equity transactions. In the case of a sale, the fund is harvesting the equity of an asset and returning that equity as a liquidating distribution to the investor. Our funds’ governing documents specify that all liquidating distributions be treated as Return of Capital for financial reporting purposes after our Preferred Return obligation is met. In essence, the refinancing of property’s debt is similar. In the cases of a cash-out refinance where a distribution is made, the partners are capturing, or are returned, a portion of the increased equity in a property through an increase in debt (leverage). Whereas a sale returns all of the remaining equity in a property, a refinance returns a portion of it. For financial reporting, when distributions are made out of sale or refinance proceeds, both are considered a Return of Capital after our Preferred Return obligation is met.
Tax reporting on these transactions differs from financial reporting. Because LLCs and LLPs are pass-through entities, there are no taxes paid at the entity level. The revenue that the entity generates less its expenses is known as net income. In these structures, the share of each investor’s net income passes through pro rata based on their percentage interest in the partnership and is reported on their personal tax return. For tax purposes, any distribution received in excess of the net allocated income represents a Return of Capital.
Return of Capital distributions can have different tax treatment. Debt financed Return of Capital distributions following a refinance are not taxable in the year received. Instead, like all distributions they reduce the adjusted tax basis of the investment and will typically result in a larger capital gain or a smaller capital loss at the time of a liquidating sale. On the other hand, distributions resulting from the sale of an asset will trigger a tax consequence. These transactions create a capital gain on the amount by which the distribution exceeds the adjusted tax basis, and this gain is subject to tax at capital gains rates under the federal tax code.
