A number of tax law provisions that impact the real estate industry have been the subject of attention in Washington of late. This client alert discusses proposed regulations released by the Treasury Department and Internal Revenue Service on January 30th on partnership debt, partner guarantees and disguised sales (the “Proposed Regulations”)¹.
The regulations are currently only in proposed form—they are not effective and it is unclear what form any final regulations may take. However, it seems clear that there is a strong impetus to address the tax treatment of partnership debt and an eventual shift to a less taxpayer-friendly approach is inevitable. For this reason, we believe it is useful to make you aware of these proposals in their formative stage. We will keep you informed of significant developments.
Many provisions in the Internal Revenue Code are believed to favor the real estate industry. Among the more popular beneficial rules are provisions such as the mortgage interest deduction and exclusions of gains (up to certain fixed dollar amounts) from the sale of a principal residence. More complex provisions of the tax law that are believed to favor real estate include the tax regime for real estate investment trusts (REITs) and the partnership tax regime, specifically in relation to how debt is treated in the partnership context.
Real estate joint ventures have for some time been able to utilize certain structures to achieve tax deferral. These structures include partnership vehicles where a partner guarantees debt, thereby increasing the partner’s “tax basis,” with the effect of allowing a distribution that might otherwise have been taxable to be tax-deferred—instead of income being recognized up-front, income can be recognized over time as the liability is paid off by the partnership (or when the partner is otherwise relieved of their share of the debt.) Like-kind exchanges are another “tax deferral” technique commonly used in the world of real estate.
These deferral strategies and a number of other “real estate tax law provisions” have been the subject of attention in Washington recently. Various proposals—some statutory (such as the “Camp Proposal”)², others regulatory (in the form of the Proposed Regulations)—could, if ultimately enacted, dramatically impact the tax treatment of real estate joint ventures.
A hallmark of real estate investments is leverage. A partner’s share of partnership debt is included in the partners “tax basis”—and tax basis is determinative of both the extent to which a partner can be allocated losses and the extent to which a partner can receive a tax-free distribution of proceeds (often represented by refinancing proceeds).
The use of non-recourse debt is prevalent in the real estate world as well, and this is both acknowledged for tax purposes and respected. Thus, though a lender may bear economic risk, current law generally allows partnership debt to be allocated among the partners taking into account guarantees provided by the partners, without requiring that the guarantees (or allocation of debt among the partners) match the other economic arrangements among the partners (i.e., the manner in which profits or losses are otherwise allocated). Furthermore, by adopting a worst-case scenario approach, the current framework can permit an allocation of debt to a partner even in situations where the actual risk of the partner having to go out of pocket to cover a liability could be somewhat remote. These guarantees are often referred to as “bottom guarantees.”
The Proposed Regulations place strong emphasis on economic reality. These new rules would dramatically change the approach and methodology for allocating partnership debt among partners. The most salient feature of the Proposed Regulations is that they require any contractual obligation (i.e., guarantee) to be “commercially reasonable” and they prevent recognition of any “bottom guarantee.” While “commercially reasonable” is not specifically defined, the Proposed Regulations incorporate this concept in various prongs of the guidance, requiring that in order for a guarantee to be “recognized” (thereby allowing the allocation of debt to the guarantor), the following factors must be met:
1. The partner is either (a) required to maintain a commercially reasonable net worth throughout the term of the liability, or (b) subject to commercially reasonable contractual restrictions on transfers of assets for inadequate consideration;
2. The partner is required periodically to provide commercially reasonable documentation regarding its financial condition;
3. The term of the partner’s obligation cannot end prior to the term of the partnership liability;
4. The partner’s obligation must not require the primary obligor (or any other obligor) to hold money or other liquid assets in an amount that exceeds the reasonable needs of such obligor;
5. The partner must receive arm’s length consideration for assuming the payment obligation;
6. In the case of a guarantee or similar arrangement, the partner would be liable for the full amount of its payment obligation if, and to the extent that, any amount of the partnership liability is not otherwise satisfied; and
7. In the case of an indemnity, reimbursement agreement, or similar arrangement, the partner would be liable for the full amount of its payment obligation if, and to the extent that, any amount of the indemnitee’s payment obligation is satisfied.
The proposals also impose a “net value” requirement for certain partners other than individuals, so that a guarantee is recognized only to the extent of a partner’s “net value” on the relevant testing dates.³
Proposed Effective Date
The version of the Proposed Regulations that was released at the end of January states that if adopted, the regulations would include a seven-year transition period for any partner whose allocable share of partnership liabilities exceeds the adjusted basis in their partnership interest on the date the new rules are finalized; however, after this point the new rules would apply to debt that pre-dates the adoption of the regulations. This means that existing structures are not fully grandfathered. Like the other provisions of the Proposed Regulations, it is possible that the effective date provisions will be modified, but there is no way to predict this outcome currently.
1The text of the Proposed Regulations can be found here: http://www.gpo.gov/fdsys/pkg/FR-2014-01-30/pdf/2014-01637.pdf
2The “Camp Proposals” refers to the proposed Tax Reform Act of 2014 released as a proposal on February 21, 2014 by Chairman of the House Committee on Ways and Means, Representative Dave Camp (R.-Mich.).
3It should be observed that while the “net value” requirement is drafted to apply to taxpayers other than individuals, the other factors enumerated (including the requirement that a partner be required to either maintain a commercially reasonable net worth, or be subjected to commercially reasonable restrictions on transfers of assets) do apply to individuals.
Questions? Contact your Berdon advisor or Kayte Steinert-Threlkeld at 212.699.6708 | firstname.lastname@example.org.