From time to time, we field questions from our investment partners regarding the classification of distributions received. The information presented below attempts 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 refinance where a debt-financed 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 allocated income. In these structures, the net allocated income passes through to the investor to be reported on their personal tax return based on their pro-rata interest in the partnership. In the tax world, any distribution that you receive 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 Return on Capital distributions, they reduce the adjusted tax basis of the investment and will typically result in a larger capital gain or a smaller capital loss when you eventually dispose of your investments. On the other hand, liquidating distributions resulting from the sale of a fund 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.