We very much doubt that the Internal Revenue Service took note of our the blog posting that follows, but on April 15, 2016, two weeks after we wrote about the significant change to the tax treatment of non-recourse carve-outs, it published a “backtracking,” some might call it a reversal, of its earlier position. You can see how it essentially reversed its earlier position by clicking: HERE.
So, the text that begins in the paragraph below the shaded one is mostly of historical significance, hopefully only an aberration. Nonetheless, we leave it posted not only to preserve history, but also for how it explains the effect of “recourse debt,” an arcane topic.
Here is the latest position of the Internal Revenue Service, as of March 31, 2016:
If a partner’s guarantee of a partnership’s nonrecourse obligation is conditioned on the occurrence of certain “nonrecourse carve-out” events described below, the guarantee will not cause the obligation to fail to qualify as a nonrecourse liability of the partnership … until such time as one of those events actually occurs and causes the guarantor to become personally liable for the partnership debt under local law.
If a partner’s guarantee of a partnership’s nonrecourse obligation is conditioned on the occurrence of certain “nonrecourse carve-out” events described below, the guarantee will not cause the obligation to fail to qualify as qualified nonrecourse financing … until such time as one of those events actually occurs and causes the guarantor to become personally liable for the partnership debt under local law.
Today’s blog posting was written with more than a little trepidation. Before we reveal its topic, Ruminations needs to emphasize two of our recurrent themes. The first is that the prime skill in counseling clients or bosses is not to know the answer, but to figure out the question – to identify possible issues, problems or opportunities. With the question in hand, most answers are easily found. Without knowing the question, the answer is useless even if in your own head.
The second highlighted theme is that you don’t need to know all of the answers or even all of the questions if you have an expert source available to you. We’ve touted the need to have a “Rolodex” (for those more recently arrived on Earth, that’s a trademark for a conveniently arranged set of cards holding names and contact information for easy retrieval). Your Rolodex should have contacts for construction issues, utility issues, insurance issues, and whatever other experts you can gather in your data base. After wading through the labyrinth of today’s technical and boring posting, you’ll want to find one or more tax experts to add to your Rolodex, probably a tax-focused accountant and even a (business) tax attorney. Today, our sole mission is to sensitize readers to a narrow tax issue brought to mind by an October 15, 2015 Tax Memorandum from your friend and ours, the Internal Revenue Service. Yes, there will be a useful, but (probably) esoteric, “fact” revealed someplace near the end of today’s posting. But, that is only to scare readers into yielding up their egos and get better connected with experts.
Today, most real estate is owned by limited liability companies. Most is financed by loans. Some of those loans, including most large ones, are structured to be “non-recourse.” To understand “non-recourse,” we first need to think of what it means for a loan to be “recourse.” To begin with, that means the lender doesn’t have to be stand back and do nothing if it isn’t getting paid. Real estate loans are almost always collateralized (or secured) by real property. And, at a minimum, if a secured lender isn’t getting paid, it can go against the collateral-property by foreclosure and apply the proceeds from a foreclosure sale toward repayment of the loan. Can it also go against other assets of its borrower? Yes, it can, unless it has agreed not to do so. It can “waive” its recourse rights against the borrower and agree to look only to the collateralized property for repayment if the loan goes sour. Lenders frequently do so.
Interestingly, in most cases, with appropriately designed limited liability company borrowers, the lender is in effectively the same position if it doesn’t waive its right to go against the borrower’s other assets. That’s because most real estate borrowers have no assets other than the real property being used for collateral. Under law, none of the limited liability company’s members have any personal liability for the debts and other obligations of the company. So, in almost all cases where there is a single asset limited liability company as a borrower, the lender has no recourse beyond the property itself. [And, that assumes that the borrower-company has avoided such things as requiring members to belly up for capital calls or including a deficit restoration obligation. Now, by the way, if a “deficit restoration obligation” seems intuitively “right,” that’s a good reason to check with a tax expert to learn the “bad” things that can come along with what feels “right.”]
Now, some lenders (and most of those making small loans) aren’t comfortable with being at risk for a shortfall in repayment if the collateral (the secured or “mortgaged” property) won’t pay off the loan at a foreclosure sale. So, they ask for personal guaranties of the entire debt; i.e., they want recourse to people or entities who aren’t their borrower. In the situation we’ll be describing as we go, many lenders have foregone such personal guaranties and agreed to take the entire “credit” risk of the loan should they not be repaid and should their collateral have insufficient value at the end of the day.
Note that when we wrote that such lenders have agreed to take the “credit” risk, we didn’t write “the entire risk.” Let’s explain. The kind of loan we’re writing about is called a “non-recourse” loan, but such loans aren’t entirely “non-recourse.” There are exceptions to the lender’s willingness to let the borrower and others completely off the hook. In the old days, the days of purity of concept, the exceptions to (or carve-outs from) a lender’s willingness to take the credit risk of nonpayment were called “bad-boy carve-outs.” [Don’t ask us why, “boy”? We hope it is an historical anachronism.] Basically, these lenders insisted that their borrowers as well as a credit worthy party (or more) guaranty the loan if the borrower or the guarantor did bad things, such as steal the borrower’s income or cause the borrower to file for bankruptcy or transfer the collateral. Today, they aren’t all “bad-boy” things. There are lists of these “bad things” and you can find them in loan documents and on the internet. Many of these bad things would cause the guarantor to be punished by a loan requirement that the borrower (and, more importantly, the guarantor) pay the entire loan when they happen. Some of the bad things aren’t “so” bad, and those same people would only cover the lender’s related losses. The lists of bad things have grown and, even though, by this time, very smart people should have figured out every possible item to be listed, the lists continue to grow.
The loan documents themselves will “carve-out” the “bad boy” list from the lender’s promise not to chase the borrower’s assets beyond the collateral. But, the “outside” guarantor, almost always a member of the limited liability company, is not a party to the loan itself, and has to sign a guaranty, commonly known as a “Non-Recourse Carve-Out Guaranty.”
[This concludes the background portion of today’s blog posting. Now, on to the “tax” portion of today’s posting.]
Real estate owners sometimes “lose” money, especially at the beginning of their ownership when the highly-prized depreciation wipes out what the “profit” would otherwise have been. Those losses, at first blush, are eligible to be applied on a tax return against each member’s other income, effectively reducing or eliminating (but, in reality, deferring) taxes that would otherwise be payable. There is a limit, however, to how much in losses from a property can be “taken” over time. Basically, you can’t count as a loss what you didn’t have to lose. So, if the most you could lose in a real estate investment is the $100 you paid for the property, the most you can deduct, over time, is $100 in losses. Once you have “wiped out” your investment, you experience no further personal losses and the excess “losses” are just on paper.
We’ve greatly simplified our example, but that allows us to retell it in a more “tax-tongued” way. Basically, you can’t lose more than you have “at risk.” In our example, all that was at risk was the $100. In our very stripped-down example, the $100 was sad sack’s tax “basis” in the property. If we were pretending to speak authoritatively, we would have said that you can’t take a tax loss in excess of the sum of your “adjusted basis” and something else we’ll be describing as we drone on. One’s adjusted basis is the amount originally paid less losses already taken and less depreciation already “realized.” If any of the losses were “repaid,” that would increase the adjusted basis. [Tax gurus, don’t get picky. This is for dummies like us.]
Now, what happens if our sad sack loser had an “adjusted basis” of $100 and borrowed $400 to buy that property where the loan was collateralized by that very property where she or he has personal liability for repayment of that loan? Well, think about why tax people talk of being “at risk.” Sad sack is at risk to lose $500; the investment and her or his personal obligation to repay the $400. So, the first $500 sad sack loses will be deductible as a loss on her or his tax return, but not the next dollar until her or his adjusted basis increases by that dollar.
Our example is translatable to when our sad sack is a member of a property owning limited liability company (LLC). Except in the most unusual of circumstances, one we’ve never seen in a non-public property owning LLC, this form of entity is taxed just like partnerships are taxed. There is no separate section of the tax “Code” for LLCs. Members of an LLC don’t directly own the company’s property; they own a share of the company. Under the Code, members (or partners) have an adjusted basis in their membership (or partnership) interests, not in the property itself. Their tax basis in those accounts takes into account what they initially invested (their “capital contribution”) and over time, increased by their share of profits, and reduced by their share of losses (and that includes depreciation) and what has been distributed to them.
As to what an LLC’s member has “at risk,” her or his (or its) adjusted basis is effectively enhanced by that member’s share of “recourse liabilities” of the LLC. [Take note, and keep in mind, that we wrote her or his (or its) “share.”]
For those who are lost at this point, we apologize, and offer an alternate explanation of what an LLC’s member has “at risk.” In doing that, we’ll paraphrase the Tax Memorandum. Generally, an LLC’s member (or a partnership’s partner) bears the economic risk of loss for the limited liability company’s liability to the extent that, if the company was (constructively) liquidated, the member would be obligated to pay some other person, such as a lender, (directly or by contribution to the company) because the debt would become payable and the member wouldn’t be entitled to be reimbursed by someone else.
When it comes to “guaranties,” what kind of guaranties would an LLC’s member have liability for if the LLC was liquidated (at which time the LLC would have to pay its obligations)? To state that differently, “Under what kind of guaranty would the (guaranteed) lender have recourse against an LLC’s member?” This is important for two reasons. First, and obviously, if the LLC member has guaranteed repayment, that would put that member “at risk” and the amount at risk would give the member an increased “cushion” against which she or he could deduct as tax losses on a current basis (and not be forced to wait until the LLC is dissolved). Second, and MOST IMPORTANT to reinforce the point of today’s rambling, if no member is “at risk” under a guaranty (or equivalent), then all of the LLC’s members get to increase their actual “at risk” amount by their share of the LLC’s “non-recourse” liabilities. Yes, the Code allows LLC members to treat the company’s “non-recourse” liabilities as if they were at risk. Don’t ask us why that is so; just say “thanks” to the tax Code.
Ruminations sees no reason to go further into the weeds by explaining what characteristics make a guaranty “non-recourse” under the Code and, by extension, what would make a guaranty, “recourse.” What we will do is sum up the problem. If one member is liable under a “recourse” guaranty for, say, the entire loan, none of the other members get any “at risk” enhancement for any part of that loan. That means that once a non-guarantying member has “used up” or “applied” her or his entire adjusted basis as losses, no further tax losses can be taken until the adjusted basis is increased or the LLC s liquidated.
Now, here is why we’ve made today’s posting. Until the October 23, 2015 Tax Memorandum was issued, everyone treated the normal “non-recourse carve-out” guaranty as “non-recourse” for tax purposes. That is, everyone acted as if it was not a guaranty for tax purposes and all members of the LLC got to deduct losses against the sum of their own adjusted basis in the LLC plus their share of the loan amount. The Tax Memorandum looked at a pretty standard non-recourse carve-out guaranty and, for tax purposes, characterized it as a “recourse” guaranty. As a result, the Memorandum concluded that the non-guarantying LLC members were limited in taking deductions for their share of the LLC’s losses because there were no “non-recourse” liabilities against which those losses could be taken. Only the member who signed (and, therefore, was liable) under a standard non-recourse carve-out guaranty could deduct losses against the amount of the loan.
Even if all of today’s posting made sense to you, unless you are a tax guru, don’t stand too close to the edge of the cliff when preparing an operating agreement or structuring a transaction, especially in a restructuring of the LLC. Of course, if today’s posting barely makes sense, our warning should be obvious. This is complicated stuff. Learn enough to know that you don’t know enough. Learn to ask questions. Find a friend, one who actually knows this stuff.
Lastly, if we haven’t yet dissuaded every reader, and you are one of those who yearns to learn what logic was behind the Tax Memorandum, click HERE to see it.
Post-lastly, we aren’t sure that the author of the Tax Memorandum got it right. We do know, however, our ignorance puts us at risk because the Memorandum concludes in a way that is contrary to what we thought we knew. The problem we have, and one we think we share with most persons similarly situated to us, is that we never really understood the basis behind “what we thought we knew.” Further, we rarely thought in terms of a property owner who experiences “losses.” What we know now is that if the deal (especially a restructuring) is even slightly complicated, we’re calling for help. What we’re not sure about is whether all traditional non-recourse carve-out guaranties are going to be treated as “recourse” guaranties for tax purposes. We can’t imagine that happening given the absolute turmoil that would cause. On the other hand, we don’t believe this Tax Memorandum was an April Fools’ Day joke from the IRS even though posting is being made during the extended holiday weekend.