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by Marc T. Finer and Ryan M. LoRusso
Albert Einstein once said “[t]he hardest thing in the world to understand is the income tax." Nowhere is this truer in the Internal Revenue Code than in the context of the recourse versus nonrecourse liability rules of Subchapter K (partnership tax). Unfortunately, for those of us who eventually do master these rules, a recent IRS Chief Counsel Advice (CCA) 201525010 confirms that we should remain humble with our accomplishment since this mastery will not necessarily prove to be of any use in classifying debt as recourse or nonrecourse in other areas of the tax code. Specifically, CCA 201525010 concludes that taxpayers may not look to the recourse/nonrecourse liability rules of Subchapter K to identify a liability as recourse or nonrecourse for purposes of determining whether a taxpayer is required to recognize cancellation of debt ("COD") income and additional gain when a lender forecloses on a taxpayer's property.
In general, a recourse liability is a liability for which the borrower is personally liable and which extends to all of the borrower's assets. Nonrecourse liabilities require the lender to look only to the property that secures the liability for repayment. In the partnership context, this determination is based on whether, and to the extent, a particular partner bears any economic risk of loss with respect to the repayment of the liability. This is important because a partner's share of partnership liabilities are included in the partner's basis in his partnership interest which affects the amount of (i) partnership losses the partner may deduct, (ii) gain or loss the partner is required to recognize on the sale of his partnership interest, and (iii) gain resulting from a cash distribution from the partnership to the partner. Classification of a partnership liability as recourse or nonrecourse is a critical first step towards properly allocating partnership liabilities among the partners and the rules for making this determination are found under Section 752 of the Internal Revenue Code (the "Code") and the accompanying Treasury Regulations.
Code Section 1001 provides the rules for calculating gain or loss on the sale or other disposition of property. Under Code Section 1001, gain or loss equals the difference between the amount realized by the taxpayer and the taxpayer's adjusted basis in the property at the time of the sale or other disposition. When property secured by a recourse liability is transferred to the lender in satisfaction of the liability (i.e., foreclosure), Code Section 1001 requires the transaction to be bifurcated - the taxpayer's amount realized from the transfer equals the fair market value of the encumbered property, and any recourse liability in excess of this fair market value is treated as COD income. By comparison, when property secured by a nonrecourse liability is transferred to the lender in satisfaction of the liability, the taxpayer's amount realized from the transfer includes the entire amount of the nonrecourse liability (with no amount characterized as COD income). This can be a critical distinction for insolvent taxpayers because COD income may be excluded from an insolvent taxpayer's income to the extent of the taxpayer's insolvency. As CCA 201525010 makes clear, the classification of a liability as recourse or nonrecourse for Code Section 752 purposes has no relevance to the classification of a liability as recourse or nonrecourse for Code Section 1001 purposes.
CCA 201525010 addressed a situation in which a group of investors formed a limited liability company ("LLC") (taxed as a partnership) as a single purpose entity ("SPE") for the sole purpose of developing real estate (the "Property"). The LLC obtained a loan to purchase the Property which was secured by a deed to the Property, a general assignment of the LLC's rights, title and interest in and to the Property, a general assignment of the members' rights, title and interest in and to the Property, pledges of membership interests in the LLC, and unlimited, unconditional and irrevocable guarantees by each LLC member. The notes that evidenced the loan did not expressly indicate whether they were recourse or nonrecourse to the LLC. The lender foreclosed on the Property when the LLC failed to make timely payments and the Property was ultimately transferred to the lender in satisfaction of the loan. For the LLC's tax year that included the foreclosure, the LLC reported the foreclosure income as COD income based on the reasoning that the loan was a recourse liability under Section 752. This COD income was passed through to the members and the members who were insolvent excluded their share of COD income from taxable income to the extent of their respective insolvencies.
The IRS field agent in the process of auditing the LLC questioned whether the loan should be treated as a nonrecourse liability to the LLC. If this was the correct result, the full amount of the loan would be included in the LLC's amount realized from the foreclosure rather than COD income and no portion of the amount could be excluded by the insolvent members. The LLC believed that since members personally guaranteed the loan, the loan met the definition of a recourse liability under the Section 752 regulations and therefore should be treated as a recourse liability for Section 1001 purposes.
Chief Counsel did not reach a conclusion as to whether the loan was recourse or nonrecourse. Importantly, however, Chief Counsel did conclude that the Section 752 regulations are not relevant to the determination of whether a liability is recourse or nonrecourse to a partnership for purposes of determining whether a partnership has COD income or increased amount realized upon foreclosure of partnership property. Rather, it deferred to the examining agent to make this determination based on a factual analysis of the operating and loan documents and any relevant state law. In doing so, Chief Counsel provided some observations to guide the examining agent in making a determination. It noted that because the LLC was an SPE, it was unable to acquire non-Property assets. As a result, the operating and loan documents did not impose full, unconditional liability on the LLC for repayment of the liability and the lender had no further recourse against the LLC once the Property and assets related to the Property were exhausted. This factor leads to the conclusion that the loan was nonrecourse. On the other hand, Chief Counsel noted that the combination of the members' pledges, general assignment of rights and guarantees in addition to the loan being secured by all of the LLC assets as a result of its status as an SPE, could be sufficient for the loan to be recourse to the entity.
CCA 201525010 offers an important lesson for real estate investors who assume that the rules for determining the treatment of a liability in the partnership tax context apply equally with respect to other provisions of the Code. Real estate investors need to be fully mindful of the differences between the definition of recourse and nonrecourse liabilities under Sections 752 and 1001 and consult with their tax and legal advisors to ensure that loan documents are drafted to account for these differences. While specifically stating that the loan is either recourse or nonrecourse in the loan documents should prove to be strong evidence of the character of the loan for Section 1001 purposes, the factors provided in CCA 201525010 should also be considered to strengthen the taxpayer's position. The failure to consider this issue in drafting the loan documents could afford the IRS with more discretion to re-characterize loans in a less taxpayer favorable manner which could result in potentially significant and unexpected adverse tax consequences.