Why The Tax Law Might Turn Your Lenders Into Investors

Gary Edelson

WASHINGTON, DC–One provision of the Tax Cut and Jobs Act, namely section 163(j), has implications that could turn lenders into investors. The end result will be the same — money for borrowers — but the nuances of the tax bill could mean that some borrowers will need to structure their deals differently. Fortunately,  most lenders should be willing to oblige.

Under Section 163(j) interest deduction will be limited to 30% of adjusted taxable income, with the exception of electing real property trade or business. One ramification, according to Montgomery McCracken Senior Tax law partner Gary M. Edelson, is that real estate limited partnerships and LLCs might use preferred membership interests or preferred LLC interests with a high yield in lieu of debt financing. Here’s why, he explains:

The new law puts a limitation on the amount of interest that can be deducted, with the excess carried forward. Business entities that use a lot of debt are going to have to work around this or they are going to face the cap. One way would be to use limited partnerships or LLCs where lenders invest, instead of lending money. It would be structured so they receive a special allocation of income, probably based on a preferred return — such as “X” amount times the amount invested. In short the LLC interest would look a bit like debt, but it technically wouldn’t be because the lender wouldn’t have creditor’s rights.

Edelson doesn’t think that banks are going to have an appetite for being limited partners but it is likely a non-bank entity that provides money may decide that it makes little difference between being a limited partner or holding an LLC interest versus being a lender and holding a debt instrument.