Page 22 —
COLORADO REAL ESTATE JOURNAL
— June 15-July 5, 2016
Law & Accounting
A
s 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 deprecia-
tion, 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 per-
sonally 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 invest-
ments. 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 inves-
tor's at-risk basis. The major dif-
ference 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 inves-
tors in a partnership. In this case,
the guarantor partners would be
allocated the
entire debt
basis that they
are person-
ally liable for,
and any other
investors in
the partner-
ship not guar-
anteeing the
debt will not
receive basis.
The “econom-
ic effect” prin-
cipal when it
comes to allo-
cating tax losses from a partner-
ship normally requires that losses
in excess of the partnership’s cap-
ital (when capital goes negative)
be allocable to those partners that
are economically liable to repay
those debts. In addition, distribu-
tions to limited partners/inves-
tors 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 pro-
visions,” or nonrecourse carve-
outs, 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 carve-
outs are 1) the borrower fails to
obtain the lender's consent before
obtaining subordinate financing
or transfer of the secured prop-
erty and 2) the borrower files a
voluntary bankruptcy petition. If
any of these events do occur, the
guarantor may then be person-
ally liable for the debt.
In April of this year the IRS
issued Legal Advice Issues by
Associate Chief Counsel regard-
ing treatment of bad-boy guar-
antees. This advice, reversing a
previous controversial opinion
in February, states that the pres-
ence alone of bad-boy guarantees
does not make the debt recourse.
Instead, it is qualified nonre-
course financing. This should
come as a relief to investors in
these partnerships because it
assures there are no hidden con-
sequences 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 author-
ity, but typically it goes along
with the IRS’ thinking on a spe-
cific issue.
Thinking simply, debt is going
to be allocated to the partners
that bear the economic risk of
loss related to that debt. Classi-
fications of debt in partnerships
and limited liability companies
holding real property can have
drastic effects on investors’ treat-
ment 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 part-
nership, causing losses to be sus-
pended 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 impera-
tive to ensure that debt passing
through schedules K-1 is classi-
fied correctly between recourse,
nonrecourse and qualified non-
recourse. 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, con-
sult your tax professional to be
sure there aren’t any unintended
consequences regarding guaran-
tees (including bad-boy guaran-
tees) that would negatively affect
you or other investors in your
partnership.
s
Kyle Bumpous,
CPA
Tax manager, Anton
Collins Mitchell LLP,
Denver
‘Bad-boy
provisions,’ or
nonrecourse
carve-outs, are
commonplace in
many nonrecourse
debt instruments
where the real
property is the
collateral.
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