Kyle Bumpous, CPA
Tax manager, Anton Collins Mitchell LLP, Denver
As I am sure you are aware, Denver’s real estate market is hot. Interest rates are low, cap rates are compressed and lenders are allowing for higher loan to value on transactions. If you couple this with very “taxpayer friendly” rules with regard to depreciation deductions (i.e., bonus depreciation, cost segregation strategies, etc.), many investors in real estate partnerships are able to generate large deficit capital accounts in early years of their investment.
On the surface, there is not much to worry about if the debt is secured by the property and there are no guarantees. If this is the case, all partners have an equal share of the debt, which creates at-risk basis. Under this scenario, the losses usually will be deducted at the individual level and everyone is happy.
Investors need to be aware of the different classifications of debt. Generally, in real estate transactions, investors prefer to have no personal liability on debt while still increasing their basis. In this scenario, the debt would be secured by the real property and no investor would be personally liable in the case of a loan default. This is what is referred to as qualified nonrecourse debt. Qualified nonrecourse financing is normally the most favorable real estate debt. QNR debt is treated as adding to an investor’s “at-risk” basis for tax purposes even though the investor is not liable for the debt. Unless passive limitations exist at the investor level, the qualified nonrecourse debt allows a taxpayer to deduct losses from real estate investments. If an investor is passive, he can deduct losses covered by qualified nonrecourse debt only to the extent of any other passive income he may have.
Recourse debt is the other type of debt that can add to an investor’s at-risk basis. The major difference being this is debt that is guaranteed by an individual and he is held personally liable in the case of a default. All other debt is considered nonrecourse and does not add to an individual’s at-risk basis.
It is possible that a loan on property is actually guaranteed personally by one or more investors in a partnership. In this case, the guarantor partners would be allocated the entire debt basis that they are personally liable for, and any other investors in the partnership not guaranteeing the debt will not receive basis. The “economic effect” principal when it comes to allocating tax losses from a partnership normally requires that losses in excess of the partnership’s capital (when capital goes negative) be allocable to those partners that are economically liable to repay those debts. In addition, distributions to limited partners/investors who have depleted or zero capital accounts may cause a shift in gross income to ensure their capital accounts do not go below zero.
Additionally, “bad-boy provisions,” or nonrecourse carveouts, are commonplace in many nonrecourse debt instruments where the real property is the collateral. These loan guarantees are conditional and assume the signor(s) of the loan agreement will not let any of the carve-out events occur. According to the IRS, two examples of carveouts are 1) the borrower fails to obtain the lender’s consent before obtaining subordinate financing or transfer of the secured property and 2) the borrower files a voluntary bankruptcy petition. If any of these events do occur, the guarantor may then be personally liable for the debt.
In April of this year the IRS issued Legal Advice Issues by Associate Chief Counsel regarding treatment of bad-boy guarantees. This advice, reversing a previous controversial opinion in February, states that the presence alone of bad-boy guarantees does not make the debt recourse. Instead, it is qualified nonrecourse financing. This should come as a relief to investors in these partnerships because it assures there are no hidden consequences to the guarantees and that all investors will receive their proportional share of the debt. It is worth noting that this advice is not considered primary authority, but typically it goes along with the IRS’ thinking on a specific issue.
Thinking simply, debt is going to be allocated to the partners that bear the economic risk of loss related to that debt. Classifications of debt in partnerships and limited liability companies holding real property can have drastic effects on investors’ treatment of pass-through losses. Guarantees on debt related to the real property by one partner could potentially reduce other partners’ at-risk basis in the partnership, causing losses to be suspended at the individual level. In the case of a refinance, if the original loan was not personally guaranteed but the refinanced loan was, you could cause basis issues for the nonguaranteeing partners, potentially resulting in recapture provisions of income or other taxable consequences to the investor group.
Additionally, it is imperative to ensure that debt passing through schedules K-1 is classified correctly between recourse, nonrecourse and qualified nonrecourse. As mentioned before, shortfalls or changes to the character of debt basis can have potentially drastic consequences to the partnership/LLC and the investors in those entities. Before closing on any financing, consult your tax professional to be sure there aren’t any unintended consequences regarding guarantees (including bad-boy guarantees) that would negatively affect you or other investors in your partnership.
