The Internal Revenue Service (IRS) recently published advice that raises concerns for investors in real estate partnerships1. The published advice changes the tax implications for investing partners when a partnership’s real estate financing document includes a so-called “bad boy guarantee,” which has been common practice.
Chief Counsel Advice (CCA) 201606027, released on February 5, 2016, concludes that a partner’s bad boy guarantee effectively converts the underlying nonrecourse financing of a partnership to a recourse liability; this in turn changes the way that each partner’s tax basis in the partnership is calculated, generally reducing tax basis for the non-guaranteeing partners and thereby limiting their ability to deduct early-year losses from the venture. Although CCA 201606027 implies that established practices may need to be changed, it is too early to say whether the published advice is an anomaly or heralds a hardened IRS stance. Regardless, all investors in real estate partnerships need to be aware of the added tax risk that bad boy guarantees now pose.
Typically, a key incentive for investors in real estate is the early-year tax loss that grows out of depreciation and interest deductions. Generally, the loss that investor-partners can deduct is limited by their tax basis in the partnership; the tax basis in turn depends on both the amount of cash invested by the partner, and the amount of partnership debt that is allocated to the partner. Under complex allocation rules, generally, if the partnership takes on recourse debt, only those partners who actually bear the economic risk of loss may include a share of the liability in their tax basis. In contrast, every partner can include in their tax basis their allocable share of the partnership’s nonrecourse liabilities. As a result, it is typically important to partners that the partnership’s financing receives nonrecourse tax treatment rather than recourse tax treatment.
Despite its tax advantage for partners, nonrecourse financing presents increased risk for lenders. Unable to seek repayment from the individual partners, nonrecourse lenders must look only to the financed property for repayment. Historically, this is true even if one or more partners have been negligent or fraudulent or have engaged in other “bad” behavior. To reduce some of their risk, lenders now routinely require nonrecourse carve-outs (NRCOs). An NRCO provides a lender with some sense of comfort, notwithstanding the non-recourse nature of the debt, by providing some recourse to guaranteeing partners if specified events occur. Under a typical type of NRCO, a guarantee is triggered if the borrower commits certain voluntary, bad acts that frustrate a lender’s ability to collect amounts owed. Most commonly, such bad acts include fraud, misapplication of funds, unauthorized transfer of the secured property, a voluntary bankruptcy filing, or acquiescence in an involuntary bankruptcy filing. Upon the occurrence of an act covered by one of these so-called bad boy guarantees, the underlying nonrecourse liability converts to a full recourse liability as to the guaranteeing partners, putting at risk those assets of the guarantors that are outside of the partnership.
Even though, in a sense, NRCOs create a type of “recourse,” tax practitioners have not viewed bad boy guarantees as changing the nonrecourse debt into a recourse liability, because the payment obligation under the guarantee is considered contingent; it is too unlikely that the guarantee would ever be triggered. Treasury Regulation Section 1.752-2 states that a payment obligation will be ignored if it is contingent on an event that is not “determinable with reasonable certainty.” Practically speaking, this appears to be the correct result, as the triggering acts of a bad boy guarantee are generally fully within the control of the guarantor and are unlikely to be triggered because, by doing so, a guarantor would be voluntarily placing themselves at risk for the full liability. Hence, tax practitioners have historically held the opinion that even if only some partners sign a bad boy guarantee, every partner of the partnership can include in their tax basis their allocable share of the liability of the underlying nonrecourse debt.
The IRS’s recent action threatens that opinion. In CCA 201606027, the IRS concludes that certain bad-boy guarantees of a partnership’s nonrecourse liability effectively convert the liability into one that is full recourse with respect to the guarantor. According to the IRS, the bad boy guarantee’s triggering events are “not so remote a possibility” that they should be disregarded. As a result, only the guarantors, and not non-guaranteeing members, are allocated the underlying liability for purposes of calculating tax basis in the partnership. The IRS holds this position even if the guarantors have the authority under the partnership agreement to call for additional contributions from the non-guaranteeing members.
The IRS position contradicts longstanding assumptions held by the real estate industry. If the IRS position is sustained, investors who are not party to a bad boy guarantee will be severely limited in the partnership losses that they can claim. We expect significant industry response to the IRS advice, but it is too early to say whether CCA 201606027 will be later reversed, or will instead become more firmly entrenched. For now, the IRS position creates uncertainty and added risk for investors. With cooperation from lenders, it might be possible to draft around the problem. However, partners should expect that such cooperation might come at the cost of concessions in the financing arrangement.
[1] https://www.irs.gov/pub/irs-wd/201606027.pdf.
If you have any questions, please contact the Hinckley Allen attorney with whom you regularly work or:
- Alexander J. Miska at [email protected]
- Avi M. Lev at [email protected]
- Stephen J. Carlotti at [email protected]