Real estate investors will be relieved to know that the Internal Revenue Service (IRS) has reversed course on a controversial position.

In our March client alert,[1] we reported that the IRS released Chief Counsel Advice (CCA) 201606027[2] on February 5, 2016, which addressed the tax implications for investing partners when a partnership’s real estate financing documents include a so-called “bad boy guarantee.” In that Advice the IRS took the position, contrary to established practice, that a bad boy guarantee effectively converts the underlying nonrecourse financing of a partnership to a recourse liability. This treatment would have the effect of limiting the ability of financial partners (who are not parties to a bad boy guarantee) to deduct expenses of the venture. As expected, this Advice was met with significant backlash from the real estate industry, as well as the tax bar, which universally doubted the merit of this Advice.

This week, the IRS released a new Chief Counsel Advice Memorandum, AM-2016-001,[3] in which it retreated from its earlier position. This new Memorandum clarifies that a bad boy guarantee will not cause an underlying nonrecourse liability to convert to a recourse liability, until such time as an act covered by the bad boy guarantee actually occurs and causes the guarantor to become personally liable for the partnership liability under local law.

This conclusion aligns with established industry practices and the IRS’s own pre-existing regulations.[4] Therefore, financial partners in real estate partnerships should expect that the IRS will respect their otherwise valid allocation of losses attributable to an underlying nonrecourse liability, even if there is a
bad boy guarantee in place.

[1] https://www.hinckleyallen.com/publications/irs-advice-on-bad-boy-guarantees-should-concern-real-estate-investors/.

[2] https://www.irs.gov/pub/irs-wd/201606027.pdf.

[3] https://www.irs.gov/pub/lanoa/am2016-001.pdf.

[4] Treasury Regulation Section 1.752-2.