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MEMORANDUM

PRIVILEGED AND CONFIDENTIAL ATTORNEY-CLIENT COMMUNICATION / ATTORNEY WORK PRODUCT

This memorandum is a privileged and confidential attorney-client communication and attorney work product prepared by Calderwood & Harkness LLP. It is intended solely for the use of the addressees identified below and may not be disclosed, disseminated, or distributed to any other person without the prior written consent of Calderwood & Harkness LLP. Unauthorized disclosure may constitute a waiver of applicable privileges.

FROM: Sylvia Hartwell, Specialist Partner, Tax Practice Group, Calderwood & Harkness LLP

TO: Douglas Fairchild, Responsible Partner, Real Estate Practice Group Angela Fontaine, Billing Partner, Real Estate Practice Group Cynthia Ho, Lead Associate Grace Nakamura, Working Associate

DATE: January 8, 2026

RE: Federal and Maryland State Tax Structure — Harbor Point Development JV, LLC

MATTER: Fairwater Real Estate Investment Trust — Institutional JV Development (Harbor Point Towers)

OFFICE: Calderwood & Harkness LLP, 100 International Drive, Suite 2600, Baltimore, MD 21202

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I. Executive Summary

The purpose of this memorandum is to summarize the federal and Maryland state tax structure for Harbor Point Development JV, LLC ("HP JV" or the "JV"), a Delaware limited liability company formed to develop the Harbor Point Towers project. Harbor Point Towers consists of two 28-story residential towers comprising approximately 610 residential rental units, together with approximately 45,000 square feet of ground-floor retail space. The project is situated on an 8.2-acre waterfront site located at 1500–1580 Wills Street, Baltimore, Maryland 21231 (Block 7419, Lots 1–6, Baltimore City), one of the most prominent development parcels remaining on the Inner Harbor waterfront.

The total project cost is estimated at approximately $576,000,000, comprising $240,000,000 in equity contributed by the two members and $336,000,000 in construction-period debt financing from Meridian National Bank, N.A. The equity capitalization is split between Fairwater HP Manager, LLC, which will hold a 30% membership interest and contribute $72,000,000, and Prescott HP Investor, LLC, which will hold a 70% membership interest and contribute $168,000,000. Fairwater HP Manager, LLC is the sole vehicle through which Fairwater Real Estate Investment Trust ("Fairwater" or the "REIT"), a publicly traded Maryland real estate investment trust listed on the New York Stock Exchange (NYSE: FWT), will participate in the venture. Prescott HP Investor, LLC is the investment vehicle of Prescott Capital Partners, LP (Fund IV, a $3.8 billion 2023 vintage institutional real estate fund).

The JV will be classified as a partnership for federal income tax purposes under the default classification rules of Treasury Regulation § 301.7701-3(b). No affirmative election to be treated as a corporation (i.e., no "check-the-box" election on Form 8832) will be filed. This classification ensures that the JV will not be subject to entity-level federal income tax; instead, all items of income, gain, loss, deduction, and credit will be allocated to and reported by the members.

This memorandum addresses the following principal tax structure and compliance topics:

1. Partnership Classification — Confirmation of default partnership status and avoidance of entity-level tax.

2. Section 704(b) Allocations — Structuring allocations of income, gain, loss, deduction, and credit to satisfy the substantial economic effect safe harbor, including capital account maintenance, qualified income offset provisions, minimum gain chargeback requirements, and the treatment of the disproportionate promote allocations under a target capital account methodology.

3. Section 704(c) Considerations — Analysis of contributed property basis, revaluation events, and the recommended allocation method for any reverse Section 704(c) layers that may arise during the life of the JV.

4. Distribution Waterfall Tax Implications — Tax characterization of each tier of the distribution waterfall, including the return of capital, preferred return, catch-up promote, and residual split tiers, with particular focus on the interaction of the promote structure with Section 1061 of the Internal Revenue Code (the "carried interest" provision).

5. Partnership Representative Designation — Designation of Fairwater HP Manager, LLC as the Partnership Representative under the centralized partnership audit regime enacted by the Bipartisan Budget Act of 2015, together with recommended protective provisions for the Operating Agreement.

6. Maryland State and Local Tax Elections — Analysis of the Maryland pass-through entity ("PTE") tax election, Baltimore City local tax considerations, withholding requirements for nonresident members, and Delaware franchise tax obligations.

7. REIT Compliance — Interaction of the JV structure with Fairwater's status as a publicly traded Maryland REIT, including analysis under the gross income tests (75% and 95%), the asset tests (75% and 10%), the distribution requirements, the prohibited transaction safe harbor, and the closely held restrictions.

8. Fee Treatment — Tax characterization of the development management fee, property management fee, and disposition fee payable to Fairwater, including analysis under Sections 707(a) and 707(c) of the Internal Revenue Code.

9. Structuring Recommendations — Specific action items for the deal team with respect to Operating Agreement tax provisions, the Tax Protection Agreement, tax return preparation and reporting protocols, and ongoing monitoring obligations.

This memorandum is intended for use by the Calderwood & Harkness LLP deal team, as well as Fairwater's General Counsel, Theresa M. Calloway, and Chief Financial Officer, Patricia S. Liang, in connection with the structuring and negotiation of the definitive transaction documents. It reflects the law as of the date hereof and should be updated to reflect any subsequent legislative, regulatory, or judicial developments prior to closing.

II. Transaction Overview and Parties

A. Joint Venture Parties

The HP JV involves two institutional participants, each investing through a special-purpose holding entity that is itself a single-member limited liability company disregarded for federal income tax purposes. The relevant entities are described below.

Fairwater HP Manager, LLC. Fairwater HP Manager, LLC is a Maryland limited liability company whose sole member is Fairwater Real Estate Investment Trust (EIN: 52-2201889), a Maryland real estate investment trust that is publicly traded on the New York Stock Exchange under the ticker symbol "FWT." Fairwater HP Manager, LLC will serve as the Managing Member of the JV, holding a 30% membership interest. In its capacity as Managing Member, Fairwater HP Manager, LLC is responsible for the day-to-day development and construction oversight of the Harbor Point Towers project, including all pre-development activities, construction management, leasing, and post-stabilization property management. Because Fairwater HP Manager, LLC is a single-member LLC, it is disregarded as a separate entity from Fairwater REIT for federal income tax purposes under Treasury Regulation § 301.7701-3(b)(1)(ii). Accordingly, all tax items allocable to Fairwater HP Manager, LLC are treated as tax items of Fairwater REIT itself.

Prescott HP Investor, LLC. Prescott HP Investor, LLC is a Delaware limited liability company whose sole member is Prescott Capital Partners, LP, a Delaware limited partnership (Fund IV, a $3.8 billion 2023 vintage institutional real estate fund) (EIN: 13-4603217). Prescott HP Investor, LLC will serve as the non-managing member of the JV, holding a 70% membership interest. Prescott HP Investor, LLC has certain protective consent rights under the Operating Agreement, including consent over major capital events (dispositions, refinancings, and additional indebtedness), annual budgets, and material amendments to the Operating Agreement. Like Fairwater HP Manager, LLC, Prescott HP Investor, LLC is a single-member LLC and therefore is disregarded as a separate entity from Prescott Capital Partners, LP for federal income tax purposes. Tax items allocable to Prescott HP Investor, LLC flow through to Prescott Capital Partners, LP, which is itself a partnership. Accordingly, such items further pass through to Prescott's limited partners and its general partner, Prescott Capital GP, LLC, in accordance with the Prescott Capital Partners, LP partnership agreement.

Harbor Point Development JV, LLC. Harbor Point Development JV, LLC is a Delaware limited liability company (EIN: 84-6213950, applied for). Its registered agent in Delaware is Incorporators & Associates, Inc., located at 1209 Orange Street, Wilmington, Delaware 19801. The JV will be qualified as a foreign limited liability company in the State of Maryland, where it will conduct all of its business operations. The JV was formed for the sole purpose of acquiring, developing, owning, leasing, operating, and ultimately disposing of the Harbor Point Towers project.

B. Capital Structure

The total equity capitalization of the JV is $240,000,000, divided between the two members as follows:

Capital will be called from the members in installments as needed to fund project costs in accordance with the approved JV budget. The initial capital call at closing is expected to be 25% of total equity commitments, or $60,000,000 in the aggregate, consisting of $18,000,000 from Fairwater and $42,000,000 from Prescott. Subsequent capital calls will be made pro rata in accordance with each member's percentage interest, upon not fewer than 15 business days' prior written notice, as approved by the JV budget. Failure by a member to fund a capital call triggers the dilution and default remedies set forth in the Operating Agreement.

The project will be financed in part with a $336,000,000 construction loan from Meridian National Bank, N.A. The loan bears interest at Term SOFR plus 275 basis points, has an initial term of 36 months with two 6-month extension options, and provides for a loan-to-cost ratio of approximately 58.33%. The loan is secured solely by the JV's assets (i.e., it is nonrecourse to the members), subject to limited recourse carve-outs pursuant to a "bad boy" guaranty provided by Fairwater and a completion guaranty also provided by Fairwater. An interest reserve of $29,400,000 is included in the soft cost budget and will be disbursed by the lender to cover debt service during the construction period.

The breakdown of total project costs is summarized as follows:

C. Distribution Waterfall (Summary for Tax Analysis Purposes)

The Operating Agreement establishes a multi-tiered distribution waterfall that governs the order in which available cash flow and capital event proceeds are distributed to the members. The waterfall is summarized below solely for the purpose of the tax analysis set forth in this memorandum:

Tier 1 — Return of Capital. 100% of available proceeds are distributed to the members pro rata in accordance with their respective percentage interests (30% to Fairwater / 70% to Prescott) until each member has received cumulative distributions equal to its total contributed capital.

Tier 2 — Preferred Return. 100% of available proceeds are distributed to the members pro rata in accordance with their respective percentage interests (30% to Fairwater / 70% to Prescott) until each member has received cumulative distributions sufficient to generate a 9.0% internal rate of return (compounded quarterly) on its unreturned capital contributions.

Tier 3 — Catch-Up. Available proceeds are distributed 60% to Fairwater (as promote) and 40% to Prescott until Fairwater has received, in the aggregate, 20% of all cumulative distributions above the return of capital (i.e., above Tier 1).

Tier 4 — Base Residual Split. After the catch-up is satisfied, remaining available proceeds are distributed 80% to Prescott and 20% to Fairwater.

Tier 5 — Second Promote Tier. If the project-level internal rate of return exceeds 15%, the residual split shifts from 80/20 to 70% Prescott / 30% Fairwater on all remaining proceeds.

It is important to note that the promote structure in Tiers 3 through 5 creates disproportionate allocations relative to the members' 30/70 base ownership percentages. In particular, Fairwater's effective economic interest increases significantly when the JV performs above the 9.0% preferred return hurdle. This disproportionality requires careful structuring of the corresponding tax allocations under Section 704(b) to ensure that allocations have substantial economic effect, as discussed in detail in Section IV below.

D. Fees to Fairwater

In addition to its share of distributions under the waterfall, Fairwater is entitled to receive the following fees from the JV in connection with services rendered in its capacity as Managing Member:

Development Management Fee. A development management fee equal to 3.5% of hard costs, calculated as $432,000,000 × 0.035 = $15,120,000. The development management fee is payable monthly during the construction period in proportion to actual hard costs incurred in the applicable period.

Property Management Fee (Post-Stabilization). A property management fee equal to 3.0% of Effective Gross Revenue, payable monthly following the achievement of stabilization of the project.

Disposition Fee. A disposition fee equal to 1.0% of the gross sale price of any JV asset, payable to Fairwater at the closing of any disposition.

No asset management fee is payable to Fairwater at the JV level. The tax characterization of each of these fees is analyzed in detail in Section IX below.

III. Partnership Classification

A. Default Classification Under Treasury Regulations

HP JV is a domestic limited liability company organized under the Delaware Limited Liability Company Act (6 Del. C. § 18-101 et seq.) with two members — Fairwater HP Manager, LLC and Prescott HP Investor, LLC. Under the entity classification rules set forth in Treasury Regulation § 301.7701-3(b)(1), a domestic eligible entity (as defined in Treasury Regulation § 301.7701-3(a)) that has two or more members is classified by default as a partnership for federal income tax purposes, unless the entity affirmatively elects to be classified as an association taxable as a corporation by filing Form 8832 (Entity Classification Election) with the Internal Revenue Service.

No affirmative "check-the-box" election will be filed by or on behalf of HP JV. The JV will rely entirely on the default partnership classification. It is critical to confirm — and the Operating Agreement should contain an affirmative representation from each member — that neither member intends to file, or has filed, Form 8832 to elect corporate classification for the JV or for its own respective single-member LLC holding vehicle. Any such election could disrupt the intended pass-through tax structure and trigger adverse consequences for both members, including potential entity-level taxation and impairment of Fairwater's REIT status.

As a practical matter, the JV's Operating Agreement should include a provision expressly prohibiting either member from filing or causing to be filed any Form 8832 or other election that would alter the JV's classification as a partnership for federal income tax purposes, absent the unanimous written consent of all members.

B. No Entity-Level Federal Income Tax

Because the JV is classified as a partnership for federal income tax purposes, it is a pass-through entity. The JV itself will not be subject to federal income tax. Instead, all items of income, gain, loss, deduction, and credit generated by the JV will be allocated to the members in accordance with the allocation provisions of the Operating Agreement and reported by each member on its own federal income tax return.

The JV will file an annual information return on Form 1065 (U.S. Return of Partnership Income) with the Internal Revenue Service and will issue a Schedule K-1 (Partner's Share of Income, Deductions, Credits, etc.) to each member. The K-1s will reflect each member's distributive share of the JV's tax items for the applicable taxable year, as determined under the allocation provisions of the Operating Agreement.

The JV has engaged Alderman & Fields, CPAs, LLP (engagement partner: Robert E. Alderman; 1 South Street, Suite 1800, Baltimore, MD 21202) to prepare the JV's annual federal and state tax returns, including Form 1065 and all associated Schedules K-1 and state-level filings. The engagement letter with Alderman & Fields should be finalized prior to closing and should address, among other things, the timeline for draft K-1 delivery, the protocol for REIT compliance data sharing, and the scope of tax advisory services during the construction and operating periods.

C. Holding-Entity Structuring

As noted above, each member invests in the JV through a single-member limited liability company — Fairwater HP Manager, LLC and Prescott HP Investor, LLC, respectively. Each of these entities is a "disregarded entity" for federal income tax purposes under Treasury Regulation § 301.7701-3(b)(1)(ii), meaning that each is treated as though it does not exist as a separate entity apart from its sole member. The result is that all tax items allocated to Fairwater HP Manager, LLC are treated as tax items of Fairwater Real Estate Investment Trust directly, and all tax items allocated to Prescott HP Investor, LLC are treated as tax items of Prescott Capital Partners, LP directly.

Prescott Capital Partners, LP is itself a limited partnership (and therefore classified as a partnership for federal income tax purposes). Accordingly, tax items flowing through from the JV to Prescott Capital Partners, LP will further pass through to Prescott's limited partners (institutional investors in Fund IV) and its general partner, Prescott Capital GP, LLC, in accordance with the allocation provisions of the Prescott Capital Partners, LP limited partnership agreement. This layered pass-through structure is standard in institutional real estate joint ventures and effectively preserves partnership-level treatment at each tier of the ownership chain, avoiding any entity-level tax at the JV, at the single-member LLC holding-entity level, or at the Prescott fund level.

For Fairwater, the disregarded entity treatment of Fairwater HP Manager, LLC is essential to ensure that Fairwater's proportionate share of the JV's assets and income is taken into account directly for purposes of the REIT qualification tests under Subchapter M of the Internal Revenue Code, as discussed in Section VIII below.

IV. Section 704(b) Allocations — Economic Effect and Substantiality

A. General Principles

Section 704(b) of the Internal Revenue Code provides that a partner's distributive share of income, gain, loss, deduction, or credit is determined by the partnership agreement if the allocation under the agreement has substantial economic effect. If an allocation lacks substantial economic effect, the partner's distributive share is determined in accordance with the partner's "interest in the partnership" — an inherently factual determination that is difficult to predict and that the IRS could apply in a manner adverse to either member. Accordingly, it is imperative that the Operating Agreement be drafted to satisfy the substantial economic effect safe harbor established by the Treasury Regulations.

The safe harbor for substantial economic effect is set forth in Treasury Regulation § 1.704-1(b)(2)(ii). Under this safe harbor, an allocation has economic effect if the partnership agreement satisfies the following three requirements:

(i) Capital Account Maintenance. The partnership agreement must provide for the maintenance of capital accounts for each partner in accordance with the rules of Treasury Regulation § 1.704-1(b)(2)(iv).

(ii) Liquidating Distributions. Upon liquidation of the partnership (or any partner's interest in the partnership), the partnership agreement must provide that liquidating distributions will be made in accordance with the partners' positive capital account balances.

(iii) Deficit Restoration or Qualified Income Offset. The partnership agreement must either require each partner with a deficit capital account balance to restore that deficit upon liquidation (an "unlimited deficit restoration obligation"), or, alternatively, include a "qualified income offset" provision as described in Treasury Regulation § 1.704-1(b)(2)(ii)(d).

The first two requirements are generally referred to as the "primary test" for economic effect, while the third requirement offers the partnership the flexibility to choose between an unlimited deficit restoration obligation or the so-called "alternate test" (qualified income offset). In the present transaction, an unlimited deficit restoration obligation is neither commercially practical nor desirable for either member, given the significant capital commitments involved and the nonrecourse nature of the construction financing. Accordingly, the alternate test is recommended — the Operating Agreement should not include an unlimited deficit restoration obligation for either member, but instead should include a qualified income offset provision.

In addition to the economic effect requirement, the allocation must also be substantive — that is, it must not be merely a shifting or transitory allocation that exists solely for the purpose of tax avoidance. The substantiality requirement is analyzed under Treasury Regulation § 1.704-1(b)(2)(iii) and is discussed in the context of the promote allocations in Section IV.G below.

B. Capital Account Maintenance

Capital accounts must be established and maintained for each member in accordance with Treasury Regulation § 1.704-1(b)(2)(iv). The Operating Agreement should incorporate, by reference or by detailed provision, the capital account maintenance rules of the regulations. At a minimum, the capital account provisions must provide as follows:

Each member's capital account is initially established at an amount equal to the cash contributed by such member (or the fair market value of any property contributed, net of liabilities assumed by the partnership or to which the contributed property is subject). Thereafter, each member's capital account is:

• Increased by: (a) the amount of additional cash contributions made by the member; (b) the fair market value of any additional property contributed by the member (net of liabilities); and (c) the member's distributive share of partnership income and gain (including tax-exempt income).

• Decreased by: (a) the amount of cash distributed to the member; (b) the fair market value of any property distributed to the member (net of liabilities); and (c) the member's distributive share of partnership loss and deduction (including expenditures described in Section 705(a)(2)(B) and similar items).

For the HP JV, the initial capital accounts will be as follows:

These amounts reflect the total equity commitments of each member. Capital accounts will be funded incrementally as capital calls are made and funded, beginning with the initial capital call of $60,000,000 at closing ($18,000,000 from Fairwater and $42,000,000 from Prescott). The capital accounts will be adjusted over time to reflect the members' shares of JV income, gain, loss, deduction, and distributions.

It should be noted that the land at 1500–1580 Wills Street is being acquired by the JV from Harbor East Land Holdings, LLC, a third-party seller, for $54,000,000 in cash. Because the JV is purchasing the land with cash (rather than receiving it as a contribution from a member), the initial book value and tax basis of the land will be aligned at $54,000,000, and no Section 704(c) allocation issue arises at formation in connection with the land. If any member contributes property other than cash — or if pre-formation expenditures are treated as a contribution of property — a Section 704(c) analysis would be required. As discussed in Section V.A below, Fairwater's pre-formation expenditures are being reimbursed and credited against its capital contribution, not treated as a contribution of property, which should avoid creating a Section 704(c) issue.

C. Liquidating Distributions

The second element of the safe harbor requires that the Operating Agreement provide that, upon liquidation of the JV (or any member's interest), liquidating distributions will be made in accordance with positive capital account balances. This means that upon a winding up of the JV's affairs, after all liabilities have been satisfied and all allocations of income, gain, loss, and deduction have been made, any remaining assets or cash will be distributed to the members in proportion to — and to the extent of — their respective positive capital account balances.

This requirement presents a fundamental structural challenge in a promoted joint venture such as HP JV, because the economic distribution waterfall during operations (including the promote tiers) does not, at any given moment, necessarily correspond to the members' capital account balances. The 60/40 catch-up, the 80/20 base residual split, and the 70/30 second promote tier all involve distributions to Fairwater in excess of its pro rata capital account balance, depending on project performance.

The recommended approach for reconciling the distribution waterfall with the capital account liquidation requirement is the "target capital account" allocation methodology. Under this approach, allocations of net income and net loss for each taxable year (or other applicable period) are not made in a fixed ratio, but rather are made to each member in such amounts as are necessary to cause each member's capital account balance, at the end of the allocation period, to equal the amount that such member would receive if, at the end of such period, (i) all JV assets were sold for their book values, (ii) all JV liabilities were paid, and (iii) all remaining net proceeds were distributed to the members pursuant to the distribution waterfall set forth in the Operating Agreement.

This "hypothetical liquidation at book value" approach effectively "reverse-engineers" the tax allocations from the economic waterfall. In years when the JV performs well and the promote tiers would be activated in a hypothetical liquidation, a disproportionately larger share of net income is allocated to Fairwater to "build up" its capital account to the level corresponding to its promote entitlement. Conversely, in years of loss or underperformance, losses may be allocated disproportionately to Fairwater to reduce its capital account to the level consistent with its lower economic entitlement in such a scenario. The result is that the members' capital accounts, at any point in time, equal the amounts they would receive in a liquidation, thereby satisfying the requirement that liquidating distributions be made in accordance with positive capital account balances.

The target capital account allocation methodology is widely accepted by tax practitioners and has been applied in numerous real estate joint ventures with similar promote structures. It is the recommended approach for the HP JV Operating Agreement.

D. Qualified Income Offset

Because neither Fairwater HP Manager, LLC nor Prescott HP Investor, LLC will have an unlimited deficit restoration obligation under the Operating Agreement, the Operating Agreement must include a qualified income offset provision in order to satisfy the alternate test for economic effect under Treasury Regulation § 1.704-1(b)(2)(ii)(d).

The qualified income offset provision requires that, if a member unexpectedly receives an adjustment, allocation, or distribution described in Treasury Regulation § 1.704-1(b)(2)(ii)(d)(4), (5), or (6) that creates or increases a deficit balance in such member's capital account in excess of any limited deficit restoration obligation that such member may have, such member will be specially allocated items of income and gain in an amount and manner sufficient to eliminate the deficit capital account balance as quickly as possible. The items of income and gain so allocated are intended to restore the member's capital account to zero, thereby preventing the member from enjoying the economic benefit of a deficit capital account that it is not obligated to restore.

The adjustments, allocations, and distributions referred to in Treasury Regulation § 1.704-1(b)(2)(ii)(d)(4), (5), and (6) include, among others, (a) reasonably expected adjustments, allocations, and distributions described in those provisions, (b) allocations of loss and deduction reasonably expected to be made to the member, and (c) distributions reasonably expected to be made to the member that would cause or increase a deficit capital account balance.

The qualified income offset provision is a mechanical requirement that protects the integrity of the safe harbor by ensuring that no member benefits from a negative capital account that it is not obligated to fund. It must be drafted carefully and should be reviewed in coordination with the minimum gain chargeback provisions described below.

E. Minimum Gain Chargeback

Under Treasury Regulation § 1.704-2, the Operating Agreement must include a "minimum gain chargeback" provision. This provision is required whenever the partnership incurs nonrecourse debt, and it operates as a backstop to ensure that members who have benefited from deductions attributable to nonrecourse debt are allocated income and gain when the economic benefit of that debt diminishes.

Specifically, if there is a net decrease in partnership minimum gain during a taxable year — which generally results from (a) the disposition of partnership property that is subject to a nonrecourse liability for an amount in excess of the property's book basis, or (b) a reduction in the amount of a nonrecourse liability below the book basis of the property securing such liability — each member must be allocated items of income and gain for such year (and, if necessary, subsequent years) equal to such member's share of the net decrease in partnership minimum gain. This allocation must be made before any other allocation of partnership items for the year.

The $336,000,000 construction loan from Meridian National Bank is nonrecourse to the members (i.e., it is secured solely by the JV's assets and no member is personally liable for repayment), subject to the limited recourse carve-outs discussed below. Partnership minimum gain will be tracked as the JV draws on the construction loan and uses the proceeds to fund construction costs. Because the loan proceeds are used to pay for construction of the improvements (which are capitalized and not immediately deducted), the creation of minimum gain during the construction period is expected to be limited. However, upon commencement of depreciation deductions on the completed improvements, nonrecourse deductions may be generated, and minimum gain will need to be monitored on an ongoing basis.

A parallel provision — the "member nonrecourse debt minimum gain chargeback" — must also be included in the Operating Agreement. This provision is implicated if any member has guaranteed, or is otherwise liable for, any portion of the JV's debt, causing that portion to be treated as "partner nonrecourse debt" under Treasury Regulation § 1.704-2(b)(4). Fairwater has provided two guaranties in connection with the Meridian National Bank construction loan:

(a) Completion Guaranty. Fairwater guarantees lien-free completion of the construction of Harbor Point Towers in accordance with the approved plans and specifications. The completion guaranty is significant because, unlike the bad boy guaranty, it creates an affirmative obligation on the part of Fairwater to fund completion costs if the JV cannot complete construction within the available loan proceeds and equity. The question is whether this guaranty creates an obligation on the part of Fairwater to "pay" a portion of the construction loan within the meaning of Treasury Regulation § 1.752-2, which would cause a portion of the loan to be treated as recourse to Fairwater (and, accordingly, as "partner nonrecourse debt" under Treasury Regulation § 1.704-2(b)(4)). This analysis is addressed in greater detail in Section X below.

(b) Bad Boy Guaranty (Recourse Carve-Out Guaranty). Fairwater has provided a standard "bad boy" or recourse carve-out guaranty that triggers only upon the occurrence of specified wrongful acts or events, including fraud, intentional misrepresentation, misapplication of funds, voluntary bankruptcy of the JV, unauthorized transfer, and environmental liability. Under Treasury Regulation § 1.752-2(b)(4), a contingent obligation that arises only upon the occurrence of certain events that are not expected to occur is generally not treated as creating a "payment obligation" for purposes of the debt allocation rules. Accordingly, the bad boy guaranty should not, by itself, cause any portion of the construction loan to be reclassified as recourse to Fairwater.

The member nonrecourse debt minimum gain chargeback provision should be included in the Operating Agreement as a precautionary measure, regardless of the ultimate characterization of the completion guaranty, to ensure compliance with the safe harbor in the event that any portion of the construction loan is treated as partner nonrecourse debt.

F. Allocation of Nonrecourse Deductions

Nonrecourse deductions are deductions funded by nonrecourse debt that create or increase partnership minimum gain. Under Treasury Regulation § 1.704-2(e), nonrecourse deductions must be allocated to the members in a manner that is reasonably consistent with allocations (which have substantial economic effect) of some other significant partnership item attributable to the property securing the nonrecourse debt.

In practice, nonrecourse deductions are typically allocated in accordance with the members' "interests in the partnership" or in a ratio reflecting their economic arrangement. For the HP JV, the most straightforward approach is to allocate nonrecourse deductions 30% to Fairwater and 70% to Prescott, consistent with the members' base equity percentages. This allocation is consistent with the members' pro rata interests in the partnership and should satisfy the regulatory requirements, provided that the allocation is not inconsistent with other allocations that have substantial economic effect.

If the members desire a different allocation of nonrecourse deductions (e.g., to shift a larger share of early-year depreciation deductions to Prescott, whose fund investors may derive greater tax benefit from such deductions), such an allocation could be structured, but it would need to be carefully analyzed to ensure compliance with the regulatory requirements. The recommendation at this time is to maintain the 30/70 allocation for simplicity and defensibility.

G. Treatment of Promote / Disproportionate Allocations

As described in Section II.C above, the promote structure in Tiers 3 through 5 of the distribution waterfall results in allocations to Fairwater in excess of its 30% base interest when the JV performs above the 9.0% preferred return hurdle. Specifically, in the catch-up tier, Fairwater receives 60% of distributions; in the base residual tier, 20%; and in the second promote tier (if the project-level IRR exceeds 15%), 30%. These percentages deviate significantly from the 30% base ownership, and the corresponding income allocations under the target capital account methodology will likewise be disproportionate.

The question arises whether these disproportionate allocations are "substantial" within the meaning of Treasury Regulation § 1.704-1(b)(2)(iii). Allocations lack substantiality if (a) they are merely "shifting" allocations (i.e., the allocation to one partner of income in a particular year is offset by a corresponding allocation of loss or deduction in a later year, with the net result being that neither partner's capital account is materially different from what it would have been under a pro rata allocation) or (b) they are "transitory" allocations (i.e., the allocations are designed to have a transitory effect that is subsequently reversed, with the overall economic positions of the partners remaining unchanged while they receive a tax benefit from the temporary reallocation).

In the HP JV structure, the promote-based allocations are not shifting or transitory. The promote varies directly and proportionally with the actual economic performance of the JV. If the JV achieves a project-level IRR above 9.0%, Fairwater's economic entitlement genuinely increases, and the income allocated to Fairwater under the target capital account methodology reflects this increased economic entitlement. Conversely, if the JV underperforms, Fairwater does not earn the promote and the allocations remain at the 30/70 base level. Because the after-tax consequences to each member depend on the actual economic outcome — which is uncertain and contingent upon real-world performance of the Harbor Point Towers project — the shifting and transitory allocation rules under Treasury Regulation § 1.704-1(b)(2)(iii) should not be implicated.

It is also important to note that the character of the promote income allocated to Fairwater will depend on the character of the underlying JV income. For example, if the promote allocation is driven by JV rental income, the promote income allocated to Fairwater will be ordinary income (rental income). If the promote allocation is driven by gain on the sale of a JV asset, the promote income allocated to Fairwater will be capital gain (subject to the Section 1061 analysis in Section IX.D below). The target capital account methodology does not independently determine the character of the allocated items; rather, character is determined at the partnership level and flows through to the members in accordance with the allocation provisions.

V. Section 704(c) Considerations

A. Applicability. Section 704(c) of the Internal Revenue Code requires that, when a partner contributes property to a partnership, and the fair market value of the contributed property differs from its adjusted tax basis at the time of contribution, the partnership must allocate income, gain, loss, and deduction with respect to such property so as to take account of the variation between the property's book value and its tax basis. The purpose of Section 704(c) is to prevent the contributing partner from shifting the built-in gain or built-in loss inherent in the contributed property to the other partners.

In the present transaction, the development site at 1500–1580 Wills Street is being acquired by the JV from Harbor East Land Holdings, LLC (sole member: Vincent A. DeLuca), a third-party seller, for $54,000,000 in cash. Because the JV is purchasing the land for cash, the JV's initial book value and tax basis in the land will both be $54,000,000. There is no difference between book value and tax basis at formation, and therefore no Section 704(c) layer arises from the land acquisition.

However, the analysis is different if Fairwater contributes pre-formation expenditures or other property in lieu of cash. Fairwater has incurred certain pre-formation costs (including design, engineering, environmental, entitlement, and due diligence expenses) in connection with the Harbor Point Towers project. Under the Pre-Formation Expenditure Reimbursement Agreement between Fairwater and the JV, these pre-formation expenditures are being reimbursed to Fairwater by the JV and credited against Fairwater's capital contribution. The pre-formation expenditures are not being treated as a contribution of property by Fairwater to the JV. Instead, the JV is treated as acquiring the benefit of these expenditures for cash (paid out of Fairwater's capital contribution), and Fairwater is treated as making a net cash contribution equal to the difference between its total capital commitment and the reimbursed pre-formation expenditures. This structure should avoid creating any Section 704(c) issue at formation. If the structure of the reimbursement arrangement changes, this conclusion should be reassessed.

B. Revaluation Events (Reverse 704(c))

Under Treasury Regulation § 1.704-1(b)(2)(iv)(f), a partnership may revalue (or "book up") the book values of its assets to fair market value upon the occurrence of certain specified events. The most common revaluation events include:

(a) The admission of a new member in exchange for a contribution to the partnership;

(b) A contribution of money or other property to the partnership by an existing member as consideration for an interest in the partnership;

(c) A distribution of money or other property by the partnership to a member in connection with a partial or full redemption of the member's interest; and

(d) The grant of an interest in the partnership (other than a de minimis interest) as consideration for the provision of services.

Upon a revaluation, the JV's capital accounts are adjusted to reflect the new book values of the JV's assets, and a new Section 704(c) layer — commonly referred to as a "reverse 704(c)" layer — arises equal to the difference between the new book value and the existing tax basis of each asset. Reverse 704(c) layers function in the same manner as traditional Section 704(c) layers: allocations of tax items with respect to the revalued assets must take account of the book-tax difference so as to prevent one member from shifting built-in gain or built-in loss to another member.

The Operating Agreement should specify the allocation method that will be used for Section 704(c) and reverse 704(c) allocations. The three permissible methods under the regulations are:

(i) Traditional Method (Treasury Regulation § 1.704-3(b)): Tax items are allocated to take account of the book-tax difference, but the allocation is limited by the "ceiling rule" — the tax allocation cannot exceed the total tax item of the partnership for the year. This method may result in a persistent book-tax discrepancy that is never fully corrected.

(ii) Traditional Method with Curative Allocations (Treasury Regulation § 1.704-3(c)): Same as the traditional method, except that the partnership may make "curative" allocations of other tax items (income, gain, loss, or deduction) to offset distortions caused by the ceiling rule.

(iii) Remedial Method (Treasury Regulation § 1.704-3(d)): The partnership creates notional remedial tax items — one item of income or gain and a corresponding item of loss or deduction — to eliminate entirely any distortion caused by the ceiling rule. This method is the most aggressive in correcting book-tax disparities.

Recommendation: The Operating Agreement should adopt the traditional method with curative allocations as the default Section 704(c) method for the HP JV. This method provides a reasonable balance between accuracy and administrative simplicity. The traditional method with curative allocations corrects distortions caused by the ceiling rule by permitting curative allocations of other partnership items, without the administrative complexity and the creation of notional tax items associated with the remedial method. The Operating Agreement should also reserve the right to switch to the remedial method if necessary to prevent material distortion — for example, in connection with a revaluation event that creates a particularly large reverse 704(c) layer.

C. Tax Protection Agreement

A separate Tax Protection Agreement is being executed between the JV, Fairwater HP Manager, LLC, and Prescott HP Investor, LLC. The Tax Protection Agreement is a customary document in institutional real estate joint ventures and serves to coordinate the tax treatment of the JV's assets and operations with the interests and requirements of the individual members. Key provisions of the Tax Protection Agreement include:

• Disposition Restrictions. Limitations on the JV's ability to dispose of assets in a manner that would trigger disproportionate taxable gain recognition to either member. For example, if a reverse 704(c) layer exists with respect to the JV's property, a sale could allocate a disproportionate share of taxable gain to the member who was admitted or contributed capital at the time of the revaluation. The Tax Protection Agreement includes restrictions on such dispositions, or requires the JV to offer gain-mitigation alternatives (such as a Section 1031 exchange or installment sale).

• Refinancing Restrictions. Limitations on refinancings that would reduce the nonrecourse debt allocable to a member, thereby triggering a deemed cash distribution under Section 752(b) that could result in gain recognition to that member.

• Gain Allocation Protections. Provisions designed to ensure that allocations of gain are made in a manner consistent with the members' economic interests and do not disproportionately burden either member.

The Tax Protection Agreement should be coordinated carefully with the allocation provisions of the Operating Agreement to ensure internal consistency. In particular, the Section 704(c) method chosen for the Operating Agreement should be referenced in the Tax Protection Agreement, and the gain allocation protections should be consistent with the target capital account allocation methodology.

VI. Partnership Representative Designation

A. BBA Partnership Audit Rules

Under the Bipartisan Budget Act of 2015 ("BBA"), the centralized partnership audit regime applies to partnership taxable years beginning after December 31, 2017. The BBA replaced the former TEFRA partnership audit procedures and introduced a streamlined regime under which the IRS audits and adjusts partnership items at the partnership level, rather than at the individual partner level.

Under the BBA regime, the JV must designate a "Partnership Representative" under Section 6223 of the Internal Revenue Code. The Partnership Representative replaces the former "Tax Matters Partner" under TEFRA and has significantly broader authority. The Partnership Representative has the sole authority to act on behalf of the JV in any federal tax proceeding involving the JV, including audits, administrative proceedings, and judicial proceedings. The actions of the Partnership Representative are binding on all members, regardless of whether the members have been consulted or have consented.

B. Designation. Under the Operating Agreement, Fairwater HP Manager, LLC will be designated as the Partnership Representative of HP JV. Because the Partnership Representative is an entity (not an individual), the regulations require the designation of a "designated individual" through whom the entity Partnership Representative will act. It is recommended that the designated individual be Patricia S. Liang, Chief Financial Officer of Fairwater Real Estate Investment Trust, or such other officer as Fairwater may designate from time to time in accordance with the Operating Agreement. The designated individual must be identified on the JV's annual Form 1065 filing.

The EIN of Fairwater HP Manager, LLC for this purpose is 52-2201889.

C. Operating Agreement Provisions

Given the expansive authority of the Partnership Representative under the BBA regime, the Operating Agreement must include robust provisions governing the exercise of this authority and protecting the interests of both members. The following provisions are recommended:

Consultation Requirement. The Partnership Representative must consult with Prescott HP Investor, LLC (and, as applicable, Prescott's counsel, Whitmore, Calder & Briggs LLP) before taking any significant action in connection with a federal tax audit or adjustment proceeding. Significant actions include, without limitation, filing any administrative or judicial protest, responding to any Information Document Request (IDR), agreeing to any extension of the statute of limitations, and making any substantive submissions to the IRS.

Consent for Settlement. The Partnership Representative shall not agree to any settlement or resolution of any federal tax audit or adjustment proceeding that would materially increase Prescott HP Investor, LLC's tax liability without the prior written consent of Prescott HP Investor, LLC, such consent not to be unreasonably withheld or delayed. The definition of "materially increase" should be negotiated and defined in the Operating Agreement (e.g., an increase exceeding a specified dollar threshold).

Notice Obligation. The Partnership Representative must provide prompt written notice to all members of any notice received from the IRS relating to an audit, examination, or adjustment of the JV's tax return, including any Notice of Administrative Proceeding (NAP), any Final Partnership Adjustment (FPA), or any other correspondence from the IRS relating to the JV's federal tax matters.

Push-Out Election. The Operating Agreement should include a covenant that the Partnership Representative will make the "push-out" election under Section 6226 of the Internal Revenue Code if requested by either member. The push-out election allows the JV to elect, within 45 days of receiving a Final Partnership Adjustment, to push the adjustment out to the "reviewed-year partners" (i.e., the partners who were members during the year under audit), rather than having the JV itself pay the imputed underpayment at the entity level. The push-out election is generally preferable for both members because it avoids entity-level tax at the JV level (which is paid at the highest marginal rate applicable to individuals) and instead allocates the adjustment to the partners who were responsible for reporting the relevant items on their own returns. The recommendation is to include an affirmative covenant requiring the Partnership Representative to make the push-out election unless both members agree in writing to an alternative approach.

Imputed Underpayment Modification. The Operating Agreement should reserve the right to modify the imputed underpayment under Section 6225(c) of the Internal Revenue Code. This provision allows the JV to reduce the imputed underpayment amount by, among other things, (a) filing amended returns on behalf of reviewed-year partners, (b) establishing that certain partners are tax-exempt or paid tax on the relevant items, and (c) making other modifications described in the regulations. Coordination with each member's own tax advisors will be essential if a modification election is pursued.

Indemnification. If the JV pays an imputed underpayment at the entity level (whether because a push-out election is not made or is not available), the member whose tax position gave rise to the underpayment should be required to indemnify the JV and the other member for the full amount of the imputed underpayment (including any interest and penalties). The indemnification obligation should survive dissolution of the JV and should be enforceable regardless of whether the indemnifying member is still a member at the time of payment.

VII. Maryland State and Local Tax Considerations

A. Maryland Pass-Through Entity Tax Election

Maryland law provides an election for pass-through entities — including partnerships and limited liability companies classified as partnerships — to pay Maryland income tax at the entity level on behalf of their members. This election is authorized under Md. Code Ann., Tax-Gen. § 10-102.1 and was enacted in response to the federal limitation on the deductibility of state and local taxes (the "SALT cap") imposed by the Tax Cuts and Jobs Act of 2017 (limiting the individual deduction for state and local taxes to $10,000 per year).

If the Maryland PTE election is made, the JV pays Maryland income tax at the entity level at the rate applicable to its members. The current top individual rate in Maryland is 8.25% (combined state and local). For entities, the rate applied depends on the character and status of the members. The benefit of the PTE election is that the entity-level tax payment is treated as a deductible expense at the entity level for federal income tax purposes, effectively allowing the JV's members to bypass the SALT cap and obtain a full federal deduction for Maryland state income taxes paid through the JV.

The interaction of the PTE election with each member's tax status is as follows:

Fairwater REIT. As a real estate investment trust, Fairwater is generally not subject to Maryland corporate income tax on income that is distributed to its shareholders (because Fairwater claims the dividends-paid deduction under Section 857(b) at the federal level, and Maryland generally conforms to this treatment). Income allocated from the JV partnership to Fairwater should qualify for the REIT dividends-paid deduction at the Fairwater level, provided that Fairwater distributes such income to its shareholders. Accordingly, the PTE election should not adversely affect Fairwater's REIT tax compliance. However, to the extent Fairwater retains income (e.g., during the construction period when distributions are limited), a Maryland corporate income tax obligation could arise. This should be monitored.

Prescott. Prescott Capital Partners, LP is a Delaware limited partnership with its principal office in New York. Its limited partners are institutional investors, many of whom are located outside Maryland. For Prescott and its investors, the PTE election may provide a meaningful SALT cap workaround — the entity-level Maryland tax payment by the JV would be deductible for federal income tax purposes, and each Prescott investor would receive a credit against its own Maryland tax obligation (if any) for its allocable share of the entity-level tax paid by the JV. The net benefit of the election depends on the individual tax circumstances of Prescott's investors, but in general, the PTE election is expected to be favorable.

Recommendation: The JV should make the Maryland PTE election if both members agree. The Operating Agreement should provide that PTE elections are "to be made as agreed" by the members, giving each member the ability to evaluate the election in light of its own tax circumstances. Alderman & Fields, CPAs, LLP should be consulted regarding the mechanics and timing of the election, which is made annually on the JV's Maryland tax return.

B. Baltimore City Local Taxes

Baltimore City imposes a local income tax in addition to the Maryland state income tax. The Maryland PTE election covers the combined state and local income tax, so a separate Baltimore City income tax filing by the JV is not required if the PTE election is made. If the PTE election is not made, the JV's members are individually responsible for their Baltimore City local income tax obligations attributable to their shares of JV income.

In addition to income taxes, the JV will be subject to the following Baltimore City and Maryland tax obligations in connection with the project:

• Personal Property Tax Returns. The JV must file annual personal property tax returns with the State of Maryland (which administers Baltimore City personal property taxes) reporting tangible personal property and certain other assets held by the JV in Baltimore City.

• Real Property Tax. The development site (Block 7419, Lots 1–6, Baltimore City) is subject to Baltimore City real property tax. The JV will be responsible for real property taxes beginning on the date of acquisition. Real property taxes in Baltimore City are assessed annually based on the assessed value of the property and improvements. During the construction period, the assessed value may increase as improvements are constructed, potentially resulting in significant property tax liability. The JV budget should include adequate reserves for real property taxes.

• Transfer and Recordation Taxes. The acquisition of the development site from Harbor East Land Holdings, LLC will trigger Maryland state and Baltimore City transfer taxes and Maryland state recordation tax. Maryland imposes a state transfer tax of 0.5% and a Baltimore City transfer tax of 1.5% (total transfer tax of 2.0%), as well as a state recordation tax of $7.00 per $500 (or fraction thereof) of consideration. On a purchase price of $54,000,000, the estimated transfer and recordation taxes are substantial and should be reflected in the soft cost budget. (Note: The actual rates and amounts should be confirmed with local counsel and the title company at the time of closing, as rates are subject to change.)

C. Withholding Requirements

Maryland requires withholding of income tax on the share of Maryland-source income allocable to nonresident members of a pass-through entity. Prescott HP Investor, LLC is a Delaware limited liability company whose sole member is Prescott Capital Partners, LP, a Delaware limited partnership with its principal office in New York. Prescott is therefore a nonresident member for Maryland withholding purposes.

If the PTE election is not made, the JV must withhold Maryland income tax on Prescott's distributive share of Maryland-source income and file Form 510 (Pass-Through Entity Tax Return) and, if applicable, Form 510C (Composite Return) or individual withholding statements for Prescott. The withholding rate is the applicable Maryland income tax rate (currently 8.25% for the highest bracket, combined state and local).

If the PTE election is made, the entity-level tax payment by the JV replaces the member-level withholding requirement. The JV pays the tax directly to the Comptroller of Maryland on behalf of all members, and each member receives a credit for its allocable share of the entity-level tax paid. This simplifies compliance and eliminates the need for separate withholding calculations and remittances.

D. Delaware Considerations

HP JV is organized as a Delaware limited liability company. Delaware does not impose an income tax on entities that do not conduct business within the State of Delaware. Because all of the JV's business operations are conducted in Maryland (the development, ownership, and operation of Harbor Point Towers), the JV has no Delaware income tax filing obligation.

The JV is, however, subject to the annual Delaware franchise tax of $300 and must maintain its registered agent in Delaware. The JV's registered agent is Incorporators & Associates, Inc., located at 1209 Orange Street, Wilmington, Delaware 19801. The franchise tax is due on or before June 1 of each year. Failure to pay the franchise tax or maintain a registered agent could result in administrative forfeiture of the JV's Delaware LLC status.

VIII. REIT Compliance — Interaction with Fairwater's Tax Status

A. Overview of REIT Requirements

Fairwater Real Estate Investment Trust is a publicly traded Maryland real estate investment trust listed on the New York Stock Exchange under the ticker symbol "FWT" (EIN: 52-2198437; Maryland State Department of Assessments and Taxation ID: D19847321). As a REIT, Fairwater is entitled to a dividends-paid deduction for distributions to its shareholders, effectively eliminating entity-level federal income tax on distributed income, provided that Fairwater satisfies the numerous qualification requirements set forth in Sections 856 through 860 of the Internal Revenue Code.

The principal REIT qualification requirements relevant to the HP JV structure include:

(i) Asset Tests (IRC § 856(c)(4)): Requirements regarding the composition of Fairwater's total assets.

(ii) Income Tests (IRC § 856(c)(2) and (c)(3)): Requirements regarding the sources of Fairwater's gross income.

(iii) Distribution Requirements (IRC § 857(a)): Requirement to distribute at least 90% of REIT taxable income annually.

(iv) Shareholder Tests (IRC § 856(a)): Requirements regarding the ownership

MEMORANDUM
PRIVILEGED AND CONFIDENTIAL ATTORNEY-CLIENT COMMUNICATION / ATTORNEY WORK PRODUCT
This memorandum is a privileged and confidential attorney-client communication and attorney work product prepared by Calderwood & Harkness LLP. It is intended solely for the use of the addressees identified below and may not be disclosed, disseminated, or distributed to any other person without the prior written consent of Calderwood & Harkness LLP. Unauthorized disclosure may constitute a waiver of applicable privileges.
FROM: Sylvia Hartwell, Specialist Partner, Tax Practice Group, Calderwood & Harkness LLP
TO: Douglas Fairchild, Responsible Partner, Real Estate Practice Group Angela Fontaine, Billing Partner, Real Estate Practice Group Cynthia Ho, Lead Associate Grace Nakamura, Working Associate
DATE: January 8, 2026
RE: Federal and Maryland State Tax Structure — Harbor Point Development JV, LLC
MATTER: Fairwater Real Estate Investment Trust — Institutional JV Development (Harbor Point Towers)
OFFICE: Calderwood & Harkness LLP, 100 International Drive, Suite 2600, Baltimore, MD 21202
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I. Executive Summary
The purpose of this memorandum is to summarize the federal and Maryland state tax structure for Harbor Point Development JV, LLC ("HP JV" or the "JV"), a Delaware limited liability company formed to develop the Harbor Point Towers project. Harbor Point Towers consists of two 28-story residential towers comprising approximately 610 residential rental units, together with approximately 45,000 square feet of ground-floor retail space. The project is situated on an 8.2-acre waterfront site located at 1500–1580 Wills Street, Baltimore, Maryland 21231 (Block 7419, Lots 1–6, Baltimore City), one of the most prominent development parcels remaining on the Inner Harbor waterfront.
The total project cost is estimated at approximately $576,000,000, comprising $240,000,000 in equity contributed by the two members and $336,000,000 in construction-period debt financing from Meridian National Bank, N.A. The equity capitalization is split between Fairwater HP Manager, LLC, which will hold a 30% membership interest and contribute $72,000,000, and Prescott HP Investor, LLC, which will hold a 70% membership interest and contribute $168,000,000. Fairwater HP Manager, LLC is the sole vehicle through which Fairwater Real Estate Investment Trust ("Fairwater" or the "REIT"), a publicly traded Maryland real estate investment trust listed on the New York Stock Exchange (NYSE: FWT), will participate in the venture. Prescott HP Investor, LLC is the investment vehicle of Prescott Capital Partners, LP (Fund IV, a $3.8 billion 2023 vintage institutional real estate fund).
The JV will be classified as a partnership for federal income tax purposes under the default classification rules of Treasury Regulation § 301.7701-3(b). No affirmative election to be treated as a corporation (i.e., no "check-the-box" election on Form 8832) will be filed. This classification ensures that the JV will not be subject to entity-level federal income tax; instead, all items of income, gain, loss, deduction, and credit will be allocated to and reported by the members.
This memorandum addresses the following principal tax structure and compliance topics:
1. Partnership Classification — Confirmation of default partnership status and avoidance of entity-level tax.
2. Section 704(b) Allocations — Structuring allocations of income, gain, loss, deduction, and credit to satisfy the substantial economic effect safe harbor, including capital account maintenance, qualified income offset provisions, minimum gain chargeback requirements, and the treatment of the disproportionate promote allocations under a target capital account methodology.
3. Section 704(c) Considerations — Analysis of contributed property basis, revaluation events, and the recommended allocation method for any reverse Section 704(c) layers that may arise during the life of the JV.
4. Distribution Waterfall Tax Implications — Tax characterization of each tier of the distribution waterfall, including the return of capital, preferred return, catch-up promote, and residual split tiers, with particular focus on the interaction of the promote structure with Section 1061 of the Internal Revenue Code (the "carried interest" provision).
5. Partnership Representative Designation — Designation of Fairwater HP Manager, LLC as the Partnership Representative under the centralized partnership audit regime enacted by the Bipartisan Budget Act of 2015, together with recommended protective provisions for the Operating Agreement.
6. Maryland State and Local Tax Elections — Analysis of the Maryland pass-through entity ("PTE") tax election, Baltimore City local tax considerations, withholding requirements for nonresident members, and Delaware franchise tax obligations.
7. REIT Compliance — Interaction of the JV structure with Fairwater's status as a publicly traded Maryland REIT, including analysis under the gross income tests (75% and 95%), the asset tests (75% and 10%), the distribution requirements, the prohibited transaction safe harbor, and the closely held restrictions.
8. Fee Treatment — Tax characterization of the development management fee, property management fee, and disposition fee payable to Fairwater, including analysis under Sections 707(a) and 707(c) of the Internal Revenue Code.
9. Structuring Recommendations — Specific action items for the deal team with respect to Operating Agreement tax provisions, the Tax Protection Agreement, tax return preparation and reporting protocols, and ongoing monitoring obligations.
This memorandum is intended for use by the Calderwood & Harkness LLP deal team, as well as Fairwater's General Counsel, Theresa M. Calloway, and Chief Financial Officer, Patricia S. Liang, in connection with the structuring and negotiation of the definitive transaction documents. It reflects the law as of the date hereof and should be updated to reflect any subsequent legislative, regulatory, or judicial developments prior to closing.
II. Transaction Overview and Parties
A. Joint Venture Parties
The HP JV involves two institutional participants, each investing through a special-purpose holding entity that is itself a single-member limited liability company disregarded for federal income tax purposes. The relevant entities are described below.
Fairwater HP Manager, LLC. Fairwater HP Manager, LLC is a Maryland limited liability company whose sole member is Fairwater Real Estate Investment Trust (EIN: 52-2201889), a Maryland real estate investment trust that is publicly traded on the New York Stock Exchange under the ticker symbol "FWT." Fairwater HP Manager, LLC will serve as the Managing Member of the JV, holding a 30% membership interest. In its capacity as Managing Member, Fairwater HP Manager, LLC is responsible for the day-to-day development and construction oversight of the Harbor Point Towers project, including all pre-development activities, construction management, leasing, and post-stabilization property management. Because Fairwater HP Manager, LLC is a single-member LLC, it is disregarded as a separate entity from Fairwater REIT for federal income tax purposes under Treasury Regulation § 301.7701-3(b)(1)(ii). Accordingly, all tax items allocable to Fairwater HP Manager, LLC are treated as tax items of Fairwater REIT itself.
Prescott HP Investor, LLC. Prescott HP Investor, LLC is a Delaware limited liability company whose sole member is Prescott Capital Partners, LP, a Delaware limited partnership (Fund IV, a $3.8 billion 2023 vintage institutional real estate fund) (EIN: 13-4603217). Prescott HP Investor, LLC will serve as the non-managing member of the JV, holding a 70% membership interest. Prescott HP Investor, LLC has certain protective consent rights under the Operating Agreement, including consent over major capital events (dispositions, refinancings, and additional indebtedness), annual budgets, and material amendments to the Operating Agreement. Like Fairwater HP Manager, LLC, Prescott HP Investor, LLC is a single-member LLC and therefore is disregarded as a separate entity from Prescott Capital Partners, LP for federal income tax purposes. Tax items allocable to Prescott HP Investor, LLC flow through to Prescott Capital Partners, LP, which is itself a partnership. Accordingly, such items further pass through to Prescott's limited partners and its general partner, Prescott Capital GP, LLC, in accordance with the Prescott Capital Partners, LP partnership agreement.
Harbor Point Development JV, LLC. Harbor Point Development JV, LLC is a Delaware limited liability company (EIN: 84-6213950, applied for). Its registered agent in Delaware is Incorporators & Associates, Inc., located at 1209 Orange Street, Wilmington, Delaware 19801. The JV will be qualified as a foreign limited liability company in the State of Maryland, where it will conduct all of its business operations. The JV was formed for the sole purpose of acquiring, developing, owning, leasing, operating, and ultimately disposing of the Harbor Point Towers project.
B. Capital Structure
The total equity capitalization of the JV is $240,000,000, divided between the two members as follows:
Capital will be called from the members in installments as needed to fund project costs in accordance with the approved JV budget. The initial capital call at closing is expected to be 25% of total equity commitments, or $60,000,000 in the aggregate, consisting of $18,000,000 from Fairwater and $42,000,000 from Prescott. Subsequent capital calls will be made pro rata in accordance with each member's percentage interest, upon not fewer than 15 business days' prior written notice, as approved by the JV budget. Failure by a member to fund a capital call triggers the dilution and default remedies set forth in the Operating Agreement.
The project will be financed in part with a $336,000,000 construction loan from Meridian National Bank, N.A. The loan bears interest at Term SOFR plus 275 basis points, has an initial term of 36 months with two 6-month extension options, and provides for a loan-to-cost ratio of approximately 58.33%. The loan is secured solely by the JV's assets (i.e., it is nonrecourse to the members), subject to limited recourse carve-outs pursuant to a "bad boy" guaranty provided by Fairwater and a completion guaranty also provided by Fairwater. An interest reserve of $29,400,000 is included in the soft cost budget and will be disbursed by the lender to cover debt service during the construction period.
The breakdown of total project costs is summarized as follows:
C. Distribution Waterfall (Summary for Tax Analysis Purposes)
The Operating Agreement establishes a multi-tiered distribution waterfall that governs the order in which available cash flow and capital event proceeds are distributed to the members. The waterfall is summarized below solely for the purpose of the tax analysis set forth in this memorandum:
Tier 1 — Return of Capital. 100% of available proceeds are distributed to the members pro rata in accordance with their respective percentage interests (30% to Fairwater / 70% to Prescott) until each member has received cumulative distributions equal to its total contributed capital.
Tier 2 — Preferred Return. 100% of available proceeds are distributed to the members pro rata in accordance with their respective percentage interests (30% to Fairwater / 70% to Prescott) until each member has received cumulative distributions sufficient to generate a 9.0% internal rate of return (compounded quarterly) on its unreturned capital contributions.
Tier 3 — Catch-Up. Available proceeds are distributed 60% to Fairwater (as promote) and 40% to Prescott until Fairwater has received, in the aggregate, 20% of all cumulative distributions above the return of capital (i.e., above Tier 1).
Tier 4 — Base Residual Split. After the catch-up is satisfied, remaining available proceeds are distributed 80% to Prescott and 20% to Fairwater.
Tier 5 — Second Promote Tier. If the project-level internal rate of return exceeds 15%, the residual split shifts from 80/20 to 70% Prescott / 30% Fairwater on all remaining proceeds.
It is important to note that the promote structure in Tiers 3 through 5 creates disproportionate allocations relative to the members' 30/70 base ownership percentages. In particular, Fairwater's effective economic interest increases significantly when the JV performs above the 9.0% preferred return hurdle. This disproportionality requires careful structuring of the corresponding tax allocations under Section 704(b) to ensure that allocations have substantial economic effect, as discussed in detail in Section IV below.
D. Fees to Fairwater
In addition to its share of distributions under the waterfall, Fairwater is entitled to receive the following fees from the JV in connection with services rendered in its capacity as Managing Member:
Development Management Fee. A development management fee equal to 3.5% of hard costs, calculated as $432,000,000 × 0.035 = $15,120,000. The development management fee is payable monthly during the construction period in proportion to actual hard costs incurred in the applicable period.
Property Management Fee (Post-Stabilization). A property management fee equal to 3.0% of Effective Gross Revenue, payable monthly following the achievement of stabilization of the project.
Disposition Fee. A disposition fee equal to 1.0% of the gross sale price of any JV asset, payable to Fairwater at the closing of any disposition.
No asset management fee is payable to Fairwater at the JV level. The tax characterization of each of these fees is analyzed in detail in Section IX below.
III. Partnership Classification
A. Default Classification Under Treasury Regulations
HP JV is a domestic limited liability company organized under the Delaware Limited Liability Company Act (6 Del. C. § 18-101 et seq.) with two members — Fairwater HP Manager, LLC and Prescott HP Investor, LLC. Under the entity classification rules set forth in Treasury Regulation § 301.7701-3(b)(1), a domestic eligible entity (as defined in Treasury Regulation § 301.7701-3(a)) that has two or more members is classified by default as a partnership for federal income tax purposes, unless the entity affirmatively elects to be classified as an association taxable as a corporation by filing Form 8832 (Entity Classification Election) with the Internal Revenue Service.
No affirmative "check-the-box" election will be filed by or on behalf of HP JV. The JV will rely entirely on the default partnership classification. It is critical to confirm — and the Operating Agreement should contain an affirmative representation from each member — that neither member intends to file, or has filed, Form 8832 to elect corporate classification for the JV or for its own respective single-member LLC holding vehicle. Any such election could disrupt the intended pass-through tax structure and trigger adverse consequences for both members, including potential entity-level taxation and impairment of Fairwater's REIT status.
As a practical matter, the JV's Operating Agreement should include a provision expressly prohibiting either member from filing or causing to be filed any Form 8832 or other election that would alter the JV's classification as a partnership for federal income tax purposes, absent the unanimous written consent of all members.
B. No Entity-Level Federal Income Tax
Because the JV is classified as a partnership for federal income tax purposes, it is a pass-through entity. The JV itself will not be subject to federal income tax. Instead, all items of income, gain, loss, deduction, and credit generated by the JV will be allocated to the members in accordance with the allocation provisions of the Operating Agreement and reported by each member on its own federal income tax return.
The JV will file an annual information return on Form 1065 (U.S. Return of Partnership Income) with the Internal Revenue Service and will issue a Schedule K-1 (Partner's Share of Income, Deductions, Credits, etc.) to each member. The K-1s will reflect each member's distributive share of the JV's tax items for the applicable taxable year, as determined under the allocation provisions of the Operating Agreement.
The JV has engaged Alderman & Fields, CPAs, LLP (engagement partner: Robert E. Alderman; 1 South Street, Suite 1800, Baltimore, MD 21202) to prepare the JV's annual federal and state tax returns, including Form 1065 and all associated Schedules K-1 and state-level filings. The engagement letter with Alderman & Fields should be finalized prior to closing and should address, among other things, the timeline for draft K-1 delivery, the protocol for REIT compliance data sharing, and the scope of tax advisory services during the construction and operating periods.
C. Holding-Entity Structuring
As noted above, each member invests in the JV through a single-member limited liability company — Fairwater HP Manager, LLC and Prescott HP Investor, LLC, respectively. Each of these entities is a "disregarded entity" for federal income tax purposes under Treasury Regulation § 301.7701-3(b)(1)(ii), meaning that each is treated as though it does not exist as a separate entity apart from its sole member. The result is that all tax items allocated to Fairwater HP Manager, LLC are treated as tax items of Fairwater Real Estate Investment Trust directly, and all tax items allocated to Prescott HP Investor, LLC are treated as tax items of Prescott Capital Partners, LP directly.
Prescott Capital Partners, LP is itself a limited partnership (and therefore classified as a partnership for federal income tax purposes). Accordingly, tax items flowing through from the JV to Prescott Capital Partners, LP will further pass through to Prescott's limited partners (institutional investors in Fund IV) and its general partner, Prescott Capital GP, LLC, in accordance with the allocation provisions of the Prescott Capital Partners, LP limited partnership agreement. This layered pass-through structure is standard in institutional real estate joint ventures and effectively preserves partnership-level treatment at each tier of the ownership chain, avoiding any entity-level tax at the JV, at the single-member LLC holding-entity level, or at the Prescott fund level.
For Fairwater, the disregarded entity treatment of Fairwater HP Manager, LLC is essential to ensure that Fairwater's proportionate share of the JV's assets and income is taken into account directly for purposes of the REIT qualification tests under Subchapter M of the Internal Revenue Code, as discussed in Section VIII below.
IV. Section 704(b) Allocations — Economic Effect and Substantiality
A. General Principles
Section 704(b) of the Internal Revenue Code provides that a partner's distributive share of income, gain, loss, deduction, or credit is determined by the partnership agreement if the allocation under the agreement has substantial economic effect. If an allocation lacks substantial economic effect, the partner's distributive share is determined in accordance with the partner's "interest in the partnership" — an inherently factual determination that is difficult to predict and that the IRS could apply in a manner adverse to either member. Accordingly, it is imperative that the Operating Agreement be drafted to satisfy the substantial economic effect safe harbor established by the Treasury Regulations.
The safe harbor for substantial economic effect is set forth in Treasury Regulation § 1.704-1(b)(2)(ii). Under this safe harbor, an allocation has economic effect if the partnership agreement satisfies the following three requirements:
(i) Capital Account Maintenance. The partnership agreement must provide for the maintenance of capital accounts for each partner in accordance with the rules of Treasury Regulation § 1.704-1(b)(2)(iv).
(ii) Liquidating Distributions. Upon liquidation of the partnership (or any partner's interest in the partnership), the partnership agreement must provide that liquidating distributions will be made in accordance with the partners' positive capital account balances.
(iii) Deficit Restoration or Qualified Income Offset. The partnership agreement must either require each partner with a deficit capital account balance to restore that deficit upon liquidation (an "unlimited deficit restoration obligation"), or, alternatively, include a "qualified income offset" provision as described in Treasury Regulation § 1.704-1(b)(2)(ii)(d).
The first two requirements are generally referred to as the "primary test" for economic effect, while the third requirement offers the partnership the flexibility to choose between an unlimited deficit restoration obligation or the so-called "alternate test" (qualified income offset). In the present transaction, an unlimited deficit restoration obligation is neither commercially practical nor desirable for either member, given the significant capital commitments involved and the nonrecourse nature of the construction financing. Accordingly, the alternate test is recommended — the Operating Agreement should not include an unlimited deficit restoration obligation for either member, but instead should include a qualified income offset provision.
In addition to the economic effect requirement, the allocation must also be substantive — that is, it must not be merely a shifting or transitory allocation that exists solely for the purpose of tax avoidance. The substantiality requirement is analyzed under Treasury Regulation § 1.704-1(b)(2)(iii) and is discussed in the context of the promote allocations in Section IV.G below.
B. Capital Account Maintenance
Capital accounts must be established and maintained for each member in accordance with Treasury Regulation § 1.704-1(b)(2)(iv). The Operating Agreement should incorporate, by reference or by detailed provision, the capital account maintenance rules of the regulations. At a minimum, the capital account provisions must provide as follows:
Each member's capital account is initially established at an amount equal to the cash contributed by such member (or the fair market value of any property contributed, net of liabilities assumed by the partnership or to which the contributed property is subject). Thereafter, each member's capital account is:
• Increased by: (a) the amount of additional cash contributions made by the member; (b) the fair market value of any additional property contributed by the member (net of liabilities); and (c) the member's distributive share of partnership income and gain (including tax-exempt income).
• Decreased by: (a) the amount of cash distributed to the member; (b) the fair market value of any property distributed to the member (net of liabilities); and (c) the member's distributive share of partnership loss and deduction (including expenditures described in Section 705(a)(2)(B) and similar items).
For the HP JV, the initial capital accounts will be as follows:
These amounts reflect the total equity commitments of each member. Capital accounts will be funded incrementally as capital calls are made and funded, beginning with the initial capital call of $60,000,000 at closing ($18,000,000 from Fairwater and $42,000,000 from Prescott). The capital accounts will be adjusted over time to reflect the members' shares of JV income, gain, loss, deduction, and distributions.
It should be noted that the land at 1500–1580 Wills Street is being acquired by the JV from Harbor East Land Holdings, LLC, a third-party seller, for $54,000,000 in cash. Because the JV is purchasing the land with cash (rather than receiving it as a contribution from a member), the initial book value and tax basis of the land will be aligned at $54,000,000, and no Section 704(c) allocation issue arises at formation in connection with the land. If any member contributes property other than cash — or if pre-formation expenditures are treated as a contribution of property — a Section 704(c) analysis would be required. As discussed in Section V.A below, Fairwater's pre-formation expenditures are being reimbursed and credited against its capital contribution, not treated as a contribution of property, which should avoid creating a Section 704(c) issue.
C. Liquidating Distributions
The second element of the safe harbor requires that the Operating Agreement provide that, upon liquidation of the JV (or any member's interest), liquidating distributions will be made in accordance with positive capital account balances. This means that upon a winding up of the JV's affairs, after all liabilities have been satisfied and all allocations of income, gain, loss, and deduction have been made, any remaining assets or cash will be distributed to the members in proportion to — and to the extent of — their respective positive capital account balances.
This requirement presents a fundamental structural challenge in a promoted joint venture such as HP JV, because the economic distribution waterfall during operations (including the promote tiers) does not, at any given moment, necessarily correspond to the members' capital account balances. The 60/40 catch-up, the 80/20 base residual split, and the 70/30 second promote tier all involve distributions to Fairwater in excess of its pro rata capital account balance, depending on project performance.
The recommended approach for reconciling the distribution waterfall with the capital account liquidation requirement is the "target capital account" allocation methodology. Under this approach, allocations of net income and net loss for each taxable year (or other applicable period) are not made in a fixed ratio, but rather are made to each member in such amounts as are necessary to cause each member's capital account balance, at the end of the allocation period, to equal the amount that such member would receive if, at the end of such period, (i) all JV assets were sold for their book values, (ii) all JV liabilities were paid, and (iii) all remaining net proceeds were distributed to the members pursuant to the distribution waterfall set forth in the Operating Agreement.
This "hypothetical liquidation at book value" approach effectively "reverse-engineers" the tax allocations from the economic waterfall. In years when the JV performs well and the promote tiers would be activated in a hypothetical liquidation, a disproportionately larger share of net income is allocated to Fairwater to "build up" its capital account to the level corresponding to its promote entitlement. Conversely, in years of loss or underperformance, losses may be allocated disproportionately to Fairwater to reduce its capital account to the level consistent with its lower economic entitlement in such a scenario. The result is that the members' capital accounts, at any point in time, equal the amounts they would receive in a liquidation, thereby satisfying the requirement that liquidating distributions be made in accordance with positive capital account balances.
The target capital account allocation methodology is widely accepted by tax practitioners and has been applied in numerous real estate joint ventures with similar promote structures. It is the recommended approach for the HP JV Operating Agreement.
D. Qualified Income Offset
Because neither Fairwater HP Manager, LLC nor Prescott HP Investor, LLC will have an unlimited deficit restoration obligation under the Operating Agreement, the Operating Agreement must include a qualified income offset provision in order to satisfy the alternate test for economic effect under Treasury Regulation § 1.704-1(b)(2)(ii)(d).
The qualified income offset provision requires that, if a member unexpectedly receives an adjustment, allocation, or distribution described in Treasury Regulation § 1.704-1(b)(2)(ii)(d)(4), (5), or (6) that creates or increases a deficit balance in such member's capital account in excess of any limited deficit restoration obligation that such member may have, such member will be specially allocated items of income and gain in an amount and manner sufficient to eliminate the deficit capital account balance as quickly as possible. The items of income and gain so allocated are intended to restore the member's capital account to zero, thereby preventing the member from enjoying the economic benefit of a deficit capital account that it is not obligated to restore.
The adjustments, allocations, and distributions referred to in Treasury Regulation § 1.704-1(b)(2)(ii)(d)(4), (5), and (6) include, among others, (a) reasonably expected adjustments, allocations, and distributions described in those provisions, (b) allocations of loss and deduction reasonably expected to be made to the member, and (c) distributions reasonably expected to be made to the member that would cause or increase a deficit capital account balance.
The qualified income offset provision is a mechanical requirement that protects the integrity of the safe harbor by ensuring that no member benefits from a negative capital account that it is not obligated to fund. It must be drafted carefully and should be reviewed in coordination with the minimum gain chargeback provisions described below.
E. Minimum Gain Chargeback
Under Treasury Regulation § 1.704-2, the Operating Agreement must include a "minimum gain chargeback" provision. This provision is required whenever the partnership incurs nonrecourse debt, and it operates as a backstop to ensure that members who have benefited from deductions attributable to nonrecourse debt are allocated income and gain when the economic benefit of that debt diminishes.
Specifically, if there is a net decrease in partnership minimum gain during a taxable year — which generally results from (a) the disposition of partnership property that is subject to a nonrecourse liability for an amount in excess of the property's book basis, or (b) a reduction in the amount of a nonrecourse liability below the book basis of the property securing such liability — each member must be allocated items of income and gain for such year (and, if necessary, subsequent years) equal to such member's share of the net decrease in partnership minimum gain. This allocation must be made before any other allocation of partnership items for the year.
The $336,000,000 construction loan from Meridian National Bank is nonrecourse to the members (i.e., it is secured solely by the JV's assets and no member is personally liable for repayment), subject to the limited recourse carve-outs discussed below. Partnership minimum gain will be tracked as the JV draws on the construction loan and uses the proceeds to fund construction costs. Because the loan proceeds are used to pay for construction of the improvements (which are capitalized and not immediately deducted), the creation of minimum gain during the construction period is expected to be limited. However, upon commencement of depreciation deductions on the completed improvements, nonrecourse deductions may be generated, and minimum gain will need to be monitored on an ongoing basis.
A parallel provision — the "member nonrecourse debt minimum gain chargeback" — must also be included in the Operating Agreement. This provision is implicated if any member has guaranteed, or is otherwise liable for, any portion of the JV's debt, causing that portion to be treated as "partner nonrecourse debt" under Treasury Regulation § 1.704-2(b)(4). Fairwater has provided two guaranties in connection with the Meridian National Bank construction loan:
(a) Completion Guaranty. Fairwater guarantees lien-free completion of the construction of Harbor Point Towers in accordance with the approved plans and specifications. The completion guaranty is significant because, unlike the bad boy guaranty, it creates an affirmative obligation on the part of Fairwater to fund completion costs if the JV cannot complete construction within the available loan proceeds and equity. The question is whether this guaranty creates an obligation on the part of Fairwater to "pay" a portion of the construction loan within the meaning of Treasury Regulation § 1.752-2, which would cause a portion of the loan to be treated as recourse to Fairwater (and, accordingly, as "partner nonrecourse debt" under Treasury Regulation § 1.704-2(b)(4)). This analysis is addressed in greater detail in Section X below.
(b) Bad Boy Guaranty (Recourse Carve-Out Guaranty). Fairwater has provided a standard "bad boy" or recourse carve-out guaranty that triggers only upon the occurrence of specified wrongful acts or events, including fraud, intentional misrepresentation, misapplication of funds, voluntary bankruptcy of the JV, unauthorized transfer, and environmental liability. Under Treasury Regulation § 1.752-2(b)(4), a contingent obligation that arises only upon the occurrence of certain events that are not expected to occur is generally not treated as creating a "payment obligation" for purposes of the debt allocation rules. Accordingly, the bad boy guaranty should not, by itself, cause any portion of the construction loan to be reclassified as recourse to Fairwater.
The member nonrecourse debt minimum gain chargeback provision should be included in the Operating Agreement as a precautionary measure, regardless of the ultimate characterization of the completion guaranty, to ensure compliance with the safe harbor in the event that any portion of the construction loan is treated as partner nonrecourse debt.
F. Allocation of Nonrecourse Deductions
Nonrecourse deductions are deductions funded by nonrecourse debt that create or increase partnership minimum gain. Under Treasury Regulation § 1.704-2(e), nonrecourse deductions must be allocated to the members in a manner that is reasonably consistent with allocations (which have substantial economic effect) of some other significant partnership item attributable to the property securing the nonrecourse debt.
In practice, nonrecourse deductions are typically allocated in accordance with the members' "interests in the partnership" or in a ratio reflecting their economic arrangement. For the HP JV, the most straightforward approach is to allocate nonrecourse deductions 30% to Fairwater and 70% to Prescott, consistent with the members' base equity percentages. This allocation is consistent with the members' pro rata interests in the partnership and should satisfy the regulatory requirements, provided that the allocation is not inconsistent with other allocations that have substantial economic effect.
If the members desire a different allocation of nonrecourse deductions (e.g., to shift a larger share of early-year depreciation deductions to Prescott, whose fund investors may derive greater tax benefit from such deductions), such an allocation could be structured, but it would need to be carefully analyzed to ensure compliance with the regulatory requirements. The recommendation at this time is to maintain the 30/70 allocation for simplicity and defensibility.
G. Treatment of Promote / Disproportionate Allocations
As described in Section II.C above, the promote structure in Tiers 3 through 5 of the distribution waterfall results in allocations to Fairwater in excess of its 30% base interest when the JV performs above the 9.0% preferred return hurdle. Specifically, in the catch-up tier, Fairwater receives 60% of distributions; in the base residual tier, 20%; and in the second promote tier (if the project-level IRR exceeds 15%), 30%. These percentages deviate significantly from the 30% base ownership, and the corresponding income allocations under the target capital account methodology will likewise be disproportionate.
The question arises whether these disproportionate allocations are "substantial" within the meaning of Treasury Regulation § 1.704-1(b)(2)(iii). Allocations lack substantiality if (a) they are merely "shifting" allocations (i.e., the allocation to one partner of income in a particular year is offset by a corresponding allocation of loss or deduction in a later year, with the net result being that neither partner's capital account is materially different from what it would have been under a pro rata allocation) or (b) they are "transitory" allocations (i.e., the allocations are designed to have a transitory effect that is subsequently reversed, with the overall economic positions of the partners remaining unchanged while they receive a tax benefit from the temporary reallocation).
In the HP JV structure, the promote-based allocations are not shifting or transitory. The promote varies directly and proportionally with the actual economic performance of the JV. If the JV achieves a project-level IRR above 9.0%, Fairwater's economic entitlement genuinely increases, and the income allocated to Fairwater under the target capital account methodology reflects this increased economic entitlement. Conversely, if the JV underperforms, Fairwater does not earn the promote and the allocations remain at the 30/70 base level. Because the after-tax consequences to each member depend on the actual economic outcome — which is uncertain and contingent upon real-world performance of the Harbor Point Towers project — the shifting and transitory allocation rules under Treasury Regulation § 1.704-1(b)(2)(iii) should not be implicated.
It is also important to note that the character of the promote income allocated to Fairwater will depend on the character of the underlying JV income. For example, if the promote allocation is driven by JV rental income, the promote income allocated to Fairwater will be ordinary income (rental income). If the promote allocation is driven by gain on the sale of a JV asset, the promote income allocated to Fairwater will be capital gain (subject to the Section 1061 analysis in Section IX.D below). The target capital account methodology does not independently determine the character of the allocated items; rather, character is determined at the partnership level and flows through to the members in accordance with the allocation provisions.
V. Section 704(c) Considerations
A. Applicability. Section 704(c) of the Internal Revenue Code requires that, when a partner contributes property to a partnership, and the fair market value of the contributed property differs from its adjusted tax basis at the time of contribution, the partnership must allocate income, gain, loss, and deduction with respect to such property so as to take account of the variation between the property's book value and its tax basis. The purpose of Section 704(c) is to prevent the contributing partner from shifting the built-in gain or built-in loss inherent in the contributed property to the other partners.
In the present transaction, the development site at 1500–1580 Wills Street is being acquired by the JV from Harbor East Land Holdings, LLC (sole member: Vincent A. DeLuca), a third-party seller, for $54,000,000 in cash. Because the JV is purchasing the land for cash, the JV's initial book value and tax basis in the land will both be $54,000,000. There is no difference between book value and tax basis at formation, and therefore no Section 704(c) layer arises from the land acquisition.
However, the analysis is different if Fairwater contributes pre-formation expenditures or other property in lieu of cash. Fairwater has incurred certain pre-formation costs (including design, engineering, environmental, entitlement, and due diligence expenses) in connection with the Harbor Point Towers project. Under the Pre-Formation Expenditure Reimbursement Agreement between Fairwater and the JV, these pre-formation expenditures are being reimbursed to Fairwater by the JV and credited against Fairwater's capital contribution. The pre-formation expenditures are not being treated as a contribution of property by Fairwater to the JV. Instead, the JV is treated as acquiring the benefit of these expenditures for cash (paid out of Fairwater's capital contribution), and Fairwater is treated as making a net cash contribution equal to the difference between its total capital commitment and the reimbursed pre-formation expenditures. This structure should avoid creating any Section 704(c) issue at formation. If the structure of the reimbursement arrangement changes, this conclusion should be reassessed.
B. Revaluation Events (Reverse 704(c))
Under Treasury Regulation § 1.704-1(b)(2)(iv)(f), a partnership may revalue (or "book up") the book values of its assets to fair market value upon the occurrence of certain specified events. The most common revaluation events include:
(a) The admission of a new member in exchange for a contribution to the partnership;
(b) A contribution of money or other property to the partnership by an existing member as consideration for an interest in the partnership;
(c) A distribution of money or other property by the partnership to a member in connection with a partial or full redemption of the member's interest; and
(d) The grant of an interest in the partnership (other than a de minimis interest) as consideration for the provision of services.
Upon a revaluation, the JV's capital accounts are adjusted to reflect the new book values of the JV's assets, and a new Section 704(c) layer — commonly referred to as a "reverse 704(c)" layer — arises equal to the difference between the new book value and the existing tax basis of each asset. Reverse 704(c) layers function in the same manner as traditional Section 704(c) layers: allocations of tax items with respect to the revalued assets must take account of the book-tax difference so as to prevent one member from shifting built-in gain or built-in loss to another member.
The Operating Agreement should specify the allocation method that will be used for Section 704(c) and reverse 704(c) allocations. The three permissible methods under the regulations are:
(i) Traditional Method (Treasury Regulation § 1.704-3(b)): Tax items are allocated to take account of the book-tax difference, but the allocation is limited by the "ceiling rule" — the tax allocation cannot exceed the total tax item of the partnership for the year. This method may result in a persistent book-tax discrepancy that is never fully corrected.
(ii) Traditional Method with Curative Allocations (Treasury Regulation § 1.704-3(c)): Same as the traditional method, except that the partnership may make "curative" allocations of other tax items (income, gain, loss, or deduction) to offset distortions caused by the ceiling rule.
(iii) Remedial Method (Treasury Regulation § 1.704-3(d)): The partnership creates notional remedial tax items — one item of income or gain and a corresponding item of loss or deduction — to eliminate entirely any distortion caused by the ceiling rule. This method is the most aggressive in correcting book-tax disparities.
Recommendation: The Operating Agreement should adopt the traditional method with curative allocations as the default Section 704(c) method for the HP JV. This method provides a reasonable balance between accuracy and administrative simplicity. The traditional method with curative allocations corrects distortions caused by the ceiling rule by permitting curative allocations of other partnership items, without the administrative complexity and the creation of notional tax items associated with the remedial method. The Operating Agreement should also reserve the right to switch to the remedial method if necessary to prevent material distortion — for example, in connection with a revaluation event that creates a particularly large reverse 704(c) layer.
C. Tax Protection Agreement
A separate Tax Protection Agreement is being executed between the JV, Fairwater HP Manager, LLC, and Prescott HP Investor, LLC. The Tax Protection Agreement is a customary document in institutional real estate joint ventures and serves to coordinate the tax treatment of the JV's assets and operations with the interests and requirements of the individual members. Key provisions of the Tax Protection Agreement include:
• Disposition Restrictions. Limitations on the JV's ability to dispose of assets in a manner that would trigger disproportionate taxable gain recognition to either member. For example, if a reverse 704(c) layer exists with respect to the JV's property, a sale could allocate a disproportionate share of taxable gain to the member who was admitted or contributed capital at the time of the revaluation. The Tax Protection Agreement includes restrictions on such dispositions, or requires the JV to offer gain-mitigation alternatives (such as a Section 1031 exchange or installment sale).
• Refinancing Restrictions. Limitations on refinancings that would reduce the nonrecourse debt allocable to a member, thereby triggering a deemed cash distribution under Section 752(b) that could result in gain recognition to that member.
• Gain Allocation Protections. Provisions designed to ensure that allocations of gain are made in a manner consistent with the members' economic interests and do not disproportionately burden either member.
The Tax Protection Agreement should be coordinated carefully with the allocation provisions of the Operating Agreement to ensure internal consistency. In particular, the Section 704(c) method chosen for the Operating Agreement should be referenced in the Tax Protection Agreement, and the gain allocation protections should be consistent with the target capital account allocation methodology.
VI. Partnership Representative Designation
A. BBA Partnership Audit Rules
Under the Bipartisan Budget Act of 2015 ("BBA"), the centralized partnership audit regime applies to partnership taxable years beginning after December 31, 2017. The BBA replaced the former TEFRA partnership audit procedures and introduced a streamlined regime under which the IRS audits and adjusts partnership items at the partnership level, rather than at the individual partner level.
Under the BBA regime, the JV must designate a "Partnership Representative" under Section 6223 of the Internal Revenue Code. The Partnership Representative replaces the former "Tax Matters Partner" under TEFRA and has significantly broader authority. The Partnership Representative has the sole authority to act on behalf of the JV in any federal tax proceeding involving the JV, including audits, administrative proceedings, and judicial proceedings. The actions of the Partnership Representative are binding on all members, regardless of whether the members have been consulted or have consented.
B. Designation. Under the Operating Agreement, Fairwater HP Manager, LLC will be designated as the Partnership Representative of HP JV. Because the Partnership Representative is an entity (not an individual), the regulations require the designation of a "designated individual" through whom the entity Partnership Representative will act. It is recommended that the designated individual be Patricia S. Liang, Chief Financial Officer of Fairwater Real Estate Investment Trust, or such other officer as Fairwater may designate from time to time in accordance with the Operating Agreement. The designated individual must be identified on the JV's annual Form 1065 filing.
The EIN of Fairwater HP Manager, LLC for this purpose is 52-2201889.
C. Operating Agreement Provisions
Given the expansive authority of the Partnership Representative under the BBA regime, the Operating Agreement must include robust provisions governing the exercise of this authority and protecting the interests of both members. The following provisions are recommended:
Consultation Requirement. The Partnership Representative must consult with Prescott HP Investor, LLC (and, as applicable, Prescott's counsel, Whitmore, Calder & Briggs LLP) before taking any significant action in connection with a federal tax audit or adjustment proceeding. Significant actions include, without limitation, filing any administrative or judicial protest, responding to any Information Document Request (IDR), agreeing to any extension of the statute of limitations, and making any substantive submissions to the IRS.
Consent for Settlement. The Partnership Representative shall not agree to any settlement or resolution of any federal tax audit or adjustment proceeding that would materially increase Prescott HP Investor, LLC's tax liability without the prior written consent of Prescott HP Investor, LLC, such consent not to be unreasonably withheld or delayed. The definition of "materially increase" should be negotiated and defined in the Operating Agreement (e.g., an increase exceeding a specified dollar threshold).
Notice Obligation. The Partnership Representative must provide prompt written notice to all members of any notice received from the IRS relating to an audit, examination, or adjustment of the JV's tax return, including any Notice of Administrative Proceeding (NAP), any Final Partnership Adjustment (FPA), or any other correspondence from the IRS relating to the JV's federal tax matters.
Push-Out Election. The Operating Agreement should include a covenant that the Partnership Representative will make the "push-out" election under Section 6226 of the Internal Revenue Code if requested by either member. The push-out election allows the JV to elect, within 45 days of receiving a Final Partnership Adjustment, to push the adjustment out to the "reviewed-year partners" (i.e., the partners who were members during the year under audit), rather than having the JV itself pay the imputed underpayment at the entity level. The push-out election is generally preferable for both members because it avoids entity-level tax at the JV level (which is paid at the highest marginal rate applicable to individuals) and instead allocates the adjustment to the partners who were responsible for reporting the relevant items on their own returns. The recommendation is to include an affirmative covenant requiring the Partnership Representative to make the push-out election unless both members agree in writing to an alternative approach.
Imputed Underpayment Modification. The Operating Agreement should reserve the right to modify the imputed underpayment under Section 6225(c) of the Internal Revenue Code. This provision allows the JV to reduce the imputed underpayment amount by, among other things, (a) filing amended returns on behalf of reviewed-year partners, (b) establishing that certain partners are tax-exempt or paid tax on the relevant items, and (c) making other modifications described in the regulations. Coordination with each member's own tax advisors will be essential if a modification election is pursued.
Indemnification. If the JV pays an imputed underpayment at the entity level (whether because a push-out election is not made or is not available), the member whose tax position gave rise to the underpayment should be required to indemnify the JV and the other member for the full amount of the imputed underpayment (including any interest and penalties). The indemnification obligation should survive dissolution of the JV and should be enforceable regardless of whether the indemnifying member is still a member at the time of payment.
VII. Maryland State and Local Tax Considerations
A. Maryland Pass-Through Entity Tax Election
Maryland law provides an election for pass-through entities — including partnerships and limited liability companies classified as partnerships — to pay Maryland income tax at the entity level on behalf of their members. This election is authorized under Md. Code Ann., Tax-Gen. § 10-102.1 and was enacted in response to the federal limitation on the deductibility of state and local taxes (the "SALT cap") imposed by the Tax Cuts and Jobs Act of 2017 (limiting the individual deduction for state and local taxes to $10,000 per year).
If the Maryland PTE election is made, the JV pays Maryland income tax at the entity level at the rate applicable to its members. The current top individual rate in Maryland is 8.25% (combined state and local). For entities, the rate applied depends on the character and status of the members. The benefit of the PTE election is that the entity-level tax payment is treated as a deductible expense at the entity level for federal income tax purposes, effectively allowing the JV's members to bypass the SALT cap and obtain a full federal deduction for Maryland state income taxes paid through the JV.
The interaction of the PTE election with each member's tax status is as follows:
Fairwater REIT. As a real estate investment trust, Fairwater is generally not subject to Maryland corporate income tax on income that is distributed to its shareholders (because Fairwater claims the dividends-paid deduction under Section 857(b) at the federal level, and Maryland generally conforms to this treatment). Income allocated from the JV partnership to Fairwater should qualify for the REIT dividends-paid deduction at the Fairwater level, provided that Fairwater distributes such income to its shareholders. Accordingly, the PTE election should not adversely affect Fairwater's REIT tax compliance. However, to the extent Fairwater retains income (e.g., during the construction period when distributions are limited), a Maryland corporate income tax obligation could arise. This should be monitored.
Prescott. Prescott Capital Partners, LP is a Delaware limited partnership with its principal office in New York. Its limited partners are institutional investors, many of whom are located outside Maryland. For Prescott and its investors, the PTE election may provide a meaningful SALT cap workaround — the entity-level Maryland tax payment by the JV would be deductible for federal income tax purposes, and each Prescott investor would receive a credit against its own Maryland tax obligation (if any) for its allocable share of the entity-level tax paid by the JV. The net benefit of the election depends on the individual tax circumstances of Prescott's investors, but in general, the PTE election is expected to be favorable.
Recommendation: The JV should make the Maryland PTE election if both members agree. The Operating Agreement should provide that PTE elections are "to be made as agreed" by the members, giving each member the ability to evaluate the election in light of its own tax circumstances. Alderman & Fields, CPAs, LLP should be consulted regarding the mechanics and timing of the election, which is made annually on the JV's Maryland tax return.
B. Baltimore City Local Taxes
Baltimore City imposes a local income tax in addition to the Maryland state income tax. The Maryland PTE election covers the combined state and local income tax, so a separate Baltimore City income tax filing by the JV is not required if the PTE election is made. If the PTE election is not made, the JV's members are individually responsible for their Baltimore City local income tax obligations attributable to their shares of JV income.
In addition to income taxes, the JV will be subject to the following Baltimore City and Maryland tax obligations in connection with the project:
• Personal Property Tax Returns. The JV must file annual personal property tax returns with the State of Maryland (which administers Baltimore City personal property taxes) reporting tangible personal property and certain other assets held by the JV in Baltimore City.
• Real Property Tax. The development site (Block 7419, Lots 1–6, Baltimore City) is subject to Baltimore City real property tax. The JV will be responsible for real property taxes beginning on the date of acquisition. Real property taxes in Baltimore City are assessed annually based on the assessed value of the property and improvements. During the construction period, the assessed value may increase as improvements are constructed, potentially resulting in significant property tax liability. The JV budget should include adequate reserves for real property taxes.
• Transfer and Recordation Taxes. The acquisition of the development site from Harbor East Land Holdings, LLC will trigger Maryland state and Baltimore City transfer taxes and Maryland state recordation tax. Maryland imposes a state transfer tax of 0.5% and a Baltimore City transfer tax of 1.5% (total transfer tax of 2.0%), as well as a state recordation tax of $7.00 per $500 (or fraction thereof) of consideration. On a purchase price of $54,000,000, the estimated transfer and recordation taxes are substantial and should be reflected in the soft cost budget. (Note: The actual rates and amounts should be confirmed with local counsel and the title company at the time of closing, as rates are subject to change.)
C. Withholding Requirements
Maryland requires withholding of income tax on the share of Maryland-source income allocable to nonresident members of a pass-through entity. Prescott HP Investor, LLC is a Delaware limited liability company whose sole member is Prescott Capital Partners, LP, a Delaware limited partnership with its principal office in New York. Prescott is therefore a nonresident member for Maryland withholding purposes.
If the PTE election is not made, the JV must withhold Maryland income tax on Prescott's distributive share of Maryland-source income and file Form 510 (Pass-Through Entity Tax Return) and, if applicable, Form 510C (Composite Return) or individual withholding statements for Prescott. The withholding rate is the applicable Maryland income tax rate (currently 8.25% for the highest bracket, combined state and local).
If the PTE election is made, the entity-level tax payment by the JV replaces the member-level withholding requirement. The JV pays the tax directly to the Comptroller of Maryland on behalf of all members, and each member receives a credit for its allocable share of the entity-level tax paid. This simplifies compliance and eliminates the need for separate withholding calculations and remittances.
D. Delaware Considerations
HP JV is organized as a Delaware limited liability company. Delaware does not impose an income tax on entities that do not conduct business within the State of Delaware. Because all of the JV's business operations are conducted in Maryland (the development, ownership, and operation of Harbor Point Towers), the JV has no Delaware income tax filing obligation.
The JV is, however, subject to the annual Delaware franchise tax of $300 and must maintain its registered agent in Delaware. The JV's registered agent is Incorporators & Associates, Inc., located at 1209 Orange Street, Wilmington, Delaware 19801. The franchise tax is due on or before June 1 of each year. Failure to pay the franchise tax or maintain a registered agent could result in administrative forfeiture of the JV's Delaware LLC status.
VIII. REIT Compliance — Interaction with Fairwater's Tax Status
A. Overview of REIT Requirements
Fairwater Real Estate Investment Trust is a publicly traded Maryland real estate investment trust listed on the New York Stock Exchange under the ticker symbol "FWT" (EIN: 52-2198437; Maryland State Department of Assessments and Taxation ID: D19847321). As a REIT, Fairwater is entitled to a dividends-paid deduction for distributions to its shareholders, effectively eliminating entity-level federal income tax on distributed income, provided that Fairwater satisfies the numerous qualification requirements set forth in Sections 856 through 860 of the Internal Revenue Code.
The principal REIT qualification requirements relevant to the HP JV structure include:
(i) Asset Tests (IRC § 856(c)(4)): Requirements regarding the composition of Fairwater's total assets.
(ii) Income Tests (IRC § 856(c)(2) and (c)(3)): Requirements regarding the sources of Fairwater's gross income.
(iii) Distribution Requirements (IRC § 857(a)): Requirement to distribute at least 90% of REIT taxable income annually.
(iv) Shareholder Tests (IRC § 856(a)): Requirements regarding the ownership

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