Avoiding At-Risk Limits in Real Estate Activities

Editor:
Albert B. Ellentuck, Esq.
Of Counsel
King & Nordlinger, L.L.P.
Arlington, VA

Editors note: This case study has been adapted from PPC Tax Planning GuidePartnerships, 16th Edition, by Grover A. Cleveland, James A. Keller, William D. Klein, Terry W. Lovelace, Sara S. McMurrian and Linda A. Markwood, published by Practitioners Publishing Company, Fort Worth, TX, 2002 ((800) 323-8724; www.ppcnet.com).

Facts: Doug, Diane and Patty each plan to acquire a one-third ownership in an existing general partnership that owns and rents apartment buildings. Each partner will purchase a one-third interest from the existing partners on Feb. 8, 2004, for $25,000. The partnership originally acquired apartment buildings costing $1 million. The partnership has a $600,000 outstanding balance on a nonrecourse first mortgage secured by the properties. The loan is from a local bank that is not a related party. The mortgage is payable in installments over 15 years at 10% interest.

The partnership plans to borrow an additional $325,000 from DT, Inc., a corporation 100% owned by Doug, to refurbish the properties. DT, Inc. is regularly engaged in the business of lending money. The note to DT, Inc. will be payable over 25 years at 3% and will be secured by a second mortgage against the properties. Each of the partners will be actively involved in the rental activities management and day-to-day operations. None of the partners has adjusted gross income in excess of $100,000.

The properties were originally placed in service by the partnership in 1984. The partners anticipate heavy repair costs in 2004 and project a $75,000 tax loss for that year. In 2005, the partnership anticipates a $30,000 net loss for tax purposes. Each of the partners has substantial passive income from other rental properties. Issue: How should the financing be structured to maximize the deductibility of projected tax losses for 2004 and 2005? How much loss from the apartment rental activities will each of the partners be able to deduct in those two years? What amount does each partner have at-risk on Jan. 1, 2005 and 2006?

Analysis

Effective for tax years beginning after 1986, real estate activities became subject to at-risk limits on losses. In general, the at-risk rules apply only to properties placed in service after 1986. However, for interests in passthrough entities (such as partnerships and S corporations) acquired after 1986, the at-risk rules apply to all properties.

Except in the case of an activity of holding real estate, Sec. 465(b)(2)(A) and (b)(6) do not allow a taxpayer to include borrowings in amounts at-risk when the taxpayer is not personally liable for repayment. Similarly, Sec. 465(b)(2)(B) does not include borrowings in the amount at-risk if they are secured by property used in the activity. When Congress included real estate activities in the at-risk loss limits, however, it also provided rather liberal exceptions to the general at-risk rules. For real estate activities only, nonrecourse debt can be included as an amount at-risk in certain circumstances. Under Sec. 465(b)(6)(A), borrowings secured by property used in the activity may also be included in the amount at-risk.

The special circumstances under which nonrecourse debt and debt secured by real property used in the activity can be included in amounts at-risk are limited to situations in which the partnership incurs qualified nonrecourse financing, defined by Sec. 465(b)(6)(B) as follows:

1. The borrowing must be made by the taxpayer with respect to the activity of holding real property.

2.The lender must be either a (i) governmental agency, or the debt must be guaranteed by a governmental agency or (ii) qualified person, defined as:

• Regularly and actively engaged in the business of lending money;

• Not the person from whom the taxpayer acquired the property;

• Not a person who received a fee with respect to the taxpayers investment in the property; and

• Not related to the taxpayer.

3. No person can be personally liable for repayment of the debt except to the extent provided in regulations. (Regs. Sec. 1.465-27(b)(4) indicates that as long as no person other than the entity classified as the partnership is liable for repayment of the financing, the personal liability will be disregarded in determining if the financing is qualified nonrecourse.)

4. The borrowing cannot be convertible debt.

A person related to the taxpayer can be a qualified person, under Sec. 465(b)(6)(D)(ii), provided that the financing is commercially reasonable and on substantially the same terms as loans involving unrelated persons. The Conference Report on the Tax Reform Act of 1986 discusses factors that should be considered in determining commercial reasonableness and states that loans bearing interest rates above or below reasonable market rates are not commercially reasonable; see Conf. Rept. No. 99-841, 99th Cong., 2d Sess. (1986), pp. 135-136.

In the situation discussed above, the nonrecourse first mortgage loan clearly fits the guidelines provided in the law because it is not convertible, is nonrecourse, was borrowed for the activity of holding real property and is from an unrelated party who neither received a fee due to the partners interests in the partnership nor sold the property to the partnership. As a consequence, the practitioner advises that the $600,000 loan from the bank can be included in the three partners amounts at-risk.

The second mortgage loan from DT, Inc. does not, as presently structured, qualify for inclusion in the partners at-risk amounts, because the lender is a related party and the note contains terms not commercially reasonablethe proposed interest rate is below a reasonable market rate and the term is unusually long for a second mortgage. The failure of this loan to qualify for inclusion in amounts at-risk does not immediately affect the partners ability to deduct losses, because the $600,000 of bank borrowings provides at-risk basis.

The tax adviser should counsel the partners to revise the terms of the second mortgage to reflect more reasonable interest rates and payment terms, so that this loan can qualify as an amount at-risk. Alternatively, the practitioner could advise the partners to seek the additional financing from an unrelated third party. The passive activity loss limits could also substantially limit the ability to deduct losses from this activity.

Conclusion

For 2004, each of the partners can deduct the full $25,000 share of the loss, because the at-risk amount includes that partners share of the $600,000 nonrecourse loan from the bank. Similarly, the full $10,000 share of the loss can be deducted by each partner in 2005. The following is a calculation of each partners amount at-risk:

Variation

The facts are the same as above, but instead of borrowing $325,000 from DT, Inc., the partnership will borrow it from First State Bank, an unrelated party. The term of the loan will be five years at 9% interest, and it is not convertible. In addition to the apartment buildings, the partnership also holds some maintenance and office equipment located in the apartment buildings. First State Bank requires the debt to be secured by the buildings and equipment and requires the partnership to be personally liable on the note.

Regs. Sec. 1.465-27(b)(4)(ii) provides a broad exception to the general rule that no one person is liable for repayment of a qualified nonrecourse debt. A partnership may be liable for repayment of a debt without preventing it from being qualified nonrecourse financing, if no other partner or entity is liable for the debt and the only assets of the partnership are real property, other property incidental to holding the real property, or de minimis property (i.e., other property that, in the aggregate has a gross fair market value (FMV) less than 10% of the aggregate gross FMV of all the property securing the financing).

The First State Bank loan meets the definition of qualified nonrecourse financing. It is a nonconvertible loan from an unrelated qualified person for the activity of holding real property. The partnerships personal liability is disregarded in determining if the financing is qualified nonrecourse financing, because its only assets are real property used in the activity of holding real property and other property incidental to that activity. Based on these facts, the First State Bank loan will provide additional at-risk for the partners.