The End Game for Co-WorkingJan 19, 2017
I have been watching – and our firm has been participating in – the co-working trend. It started with Regus when it was founded in 1989 but didn’t really go anywhere until the past few years. Since then, numerous players have entered the market, each with its own twist to appeal to different parties.
There is an ongoing debate as to what will happen during the next downturn. Some say that the co-working spaces – filled with millennials – will become ghost towns as these millennials will go home to work out of their parents’ basements for free. Others say that in a downturn, co-working will boom even more because there will be more people out of work.
I am not wading into this debate except to say that I am certain that no one has a crystal ball and we will just have to see what happens at the time of the next downturn. If I had to guess – and I shouldn’t guess publicly – I think the latter (i.e. the boom) is much more likely than the bust, but that is just my guess. However, I do have a perspective here that I think is interesting….
To take you through my thinking, I hearken back to the internet. When it started, everyone was so excited. It was a “new business” and everyone was pouring into it. However, it turned out that it was really not “a new business”; instead, it was “a new way of doing business.” This meant that WalMart could be in the business just as easily as an internet start-up. If you fast-forward about twenty years, I don’t think there is a single business that exists today that is truly an “internet business”, with the single exception of Amazon and, at least according to my calculations, it is only just now starting to turn a profit. So much for the “internet business”.
I think the exact same analysis applies to co-working. If you look at what is happening now, there are numerous competitors; however, recently, landlords themselves have started to enter the fray. For example, if you own an office building, you might consider allocating a floor for co-working space. The margins are dramatically higher than what you would get if you leased the floor – versus the risk that your tenants are sort of like hotel guests and could evaporate if the market changes.
To be clear here, since co-working is so labor and operationally intensive, most landlords will team up with a co-working provider. I think you will see a lot more of this.
As a landlord you wouldn’t want to risk the entire building on this concept just yet and even if you did your lender wouldn’t let you, but for a single floor it probably makes sense to take a chance and enjoy the upside without that much downside risk. And ten years from now, once co-working has proven to be a longer-lasting concept, your lender will probably let you co-work out half of your building or even more than that, i.e. co-working will likely morph to be more like a hotel concept.
In any case, over the next ten years I suspect co-working will become more and more ubiquitous. Then what happens to the co-working companies?
My prediction is that there will be a couple of survivors. The rest will fold or be absorbed or bought by other real estate players.
Meanwhile, I advocate that real estate players – worldwide – should be looking at how they can optimally apply this “new way of doing business.”
Big change in partnership debt rules
Heads up real estate community: there are new tax rules applicable to partnership debt! The new guidance affects how debt is allocated for tax purposes, which determines how much money you can take out of a partnership tax-free.
Under the old rules: The tax rules used to allow you to refinance a property and pull out cash, contribute that newly refinanced property to a partnership, and have the partnership assume the debt, all without paying any tax. The trick here was that you had to guarantee the debt so that you were allocated the debt for tax purposes (this would increase your basis in your partnership interest – the higher your basis, the more distributions you can receive tax-free). That guarantee was your ticket to an exception to the “disguised sale” rules which otherwise would have treated you as having sold the property to the partnership in exchange for the amount of the debt.
For example, assume a developer had property that he bought for $500k which later goes up in value to $2m. If he refinanced the property with a new loan for $1m, kept the $1m cash, contributed the property to a partnership for a 25% interest and had the partnership assume the debt, the developer just got $1m tax-free, as long as he guaranteed the debt. In some instances, the guarantee could even have been a “bottom dollar” guarantee so that it was unlikely to ever be called upon.
Under the new rules: This guarantee technique no longer works. Any contributions of recently refinanced property, and any contributions of property followed by cash distributions of newly borrowed money from the partnership, are treated, at least in part, as sales of the property to the partnership.
Assume the same facts as above (the developer refinances his property, pulls out $1m cash, and contributes the property to a partnership for a 25% interest). Even if the developer guarantees the debt, the developer will be treated as if he sold part of the property to the partnership in exchange for $750k (the difference between the $1m debt and the developer’s 25% share of the debt, i.e. $250k). The developer’s $500k basis in the property would have to be split between the portion of the property deemed sold to the partnership and the portion of the property deemed contributed to the property. Since a portion of the property was deemed sold for $750k, which is 37.5% of the value of the property, 37.5% of the basis ($187,500) can be allocated to the portion that was sold. So the developer would have taxable gain of $562,500 (the difference between $750k and $187,500k).
The new rule applies to contributions of property to partnerships on or after January 3, 2017.
If you are considering a structure that uses partnership debt to finance distributions, please feel free to reach out to a partner in our Tax Practice Group.
- Stephen Land, +1 (212) 692-5991, firstname.lastname@example.org.
- Jessica Millett, +1 (212) 692-5988, email@example.com.