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Treasury Issues Final Regulations Modifying Rules for Allocating Real Estate Debt Among Partners

  • October 11, 2019

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Final regulations released by the Treasury Department last Friday and effective October 9 provide new tax guidance on the allocation of liabilities between partners in a real estate partnership.  The new rules bring to a conclusion a regulatory project that started over six years ago.

  • How real estate debt and other liabilities are allocated among partners when property is contributed to a partnership carry important tax consequences.  Allocation rules can determine whether built-in gain is recognized or deferred at the time of the contribution.  The rules also affect whether a partner obtains sufficient tax basis to deduct future losses.  Generally, a partner receives full basis for partnership debt if the debt is recourse and the partner is obligated to pay off the loan in the event the partnership defaults.
  • The new regulations will likely complicate taxpayers’ ability to achieve a preferred allocation of real estate liabilities (and deductions) through the use of liability guarantees such as “bottom guarantees,” capital account deficit restoration obligations, and other payment or reimbursement arrangements. 
  • A bottom guarantee is a guarantee of the last dollars of a liability.  The lender may pursue the guarantor only if the lender is unable to collect at least the guaranteed amount of the loan from the borrower.  The final rules will largely restrict the use of bottom guarantees.  Treasury expressed concerns that bottom guarantees lack a non-tax commercial purpose, are “structured to insulate the obligor from having to pay,” and do not represent a real economic risk of loss.
  • On four separate occasions, The Roundtable submitted comments on the partnership liability regulatory project, which began in 2013. Additionally, a working group from The Roundtable’s Tax Policy Advisory Committee (TPAC) previously met with Treasury and IRS officials.  The Roundtable had concerns that changes would disrupt longstanding partnership tax rules and increase the tax liability of previously untaxed real estate reorganization transactions.  [Roundtable Comment Letters: March 13, 2013 and April 7, 2017  and August 7, 2017 
  • Input from The Roundtable, TPAC members and other stakeholders contributed to several revisions to the proposed rules over the last five years.  The rules published in the Federal Register on October 9 finalize temporary regulations under section 752 that were released in 2016 and scheduled to expire this month.  Those 2016 regulations were revised versions of the rules initially proposed in 2014.  The October 9 rules also finalize proposed regulations issued in June 2018 that walked back 2016 proposed regulations with respect to the allocation of debt in “disguised sales” transactions under section 707. 
  • The preamble to the final rules notes that Treasury continues to consider the appropriate treatment of “exculpatory liabilities” that are recourse to an entity under state law, but where no partner bears the economic risk of loss.

The final regulations provide critical transition relief.  The rules generally apply to liabilities incurred or assumed by a partnership, and to payment obligations imposed or undertaken with respect to a partnership liability, on or after October 9, 2019.  The new restrictions do not apply if the liability was incurred or assumed by a partnership, or the payment obligation was imposed or undertaken, pursuant to a written binding contract in effect prior to October 9.

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