IRS Issues New Regulations on Treatment of Recourse Loans for Partnerships

Tony Salazar, CPA, MST

The IRS recently released new final regulations addressing the proper allocation of recourse debt among partners under Sec. 752 of the Internal Revenue Code. The regulations modify and clarify the proposed regulations issued in 2013. Here is what partnerships and partners need to know.

Debt Allocation and Sec. 752

A partner’s share of the partnership’s debt is included in the partner’s outside basis — that is, the partner’s basis in its partnership interest. A partner’s outside basis is critical because it affects:

• The maximum amount of any deduction or loss that passes through to the partner;
• The gain or loss from the disposition of a partnership interest; and
• The tax consequences of cash and property distributions.

Sec. 752 is intended to ensure the proper alignment between a partner’s outside basis and its share of the partnership’s debt based on the partner’s economic risk of loss (EROL) with respect to the partnership.  

It generally provides that an increase in a partner’s share of partnership liabilities (or in a partner’s individual liabilities due to the partner’s assumption of partnership liabilities) is considered a contribution of money to the partnership — which increases the partner’s outside basis. Conversely, a reduction in a partner’s share of partnership debt (or in a partner’s individual liabilities due to the partnership’s assumption of such liabilities) is treated as a distribution of money to the partner and therefore reduces basis.

Liabilities under Sec. 752 generally are recourse or nonrecourse. A partnership liability is recourse to the extent that the partner — or a related person — bears the EROL. A debt is nonrecourse if no partner or related party bears the EROL.

A partner bears the EROL for a recourse liability to the extent that, in a “constructive liquidation” of the partnership, the partner or a related person would have a payment obligation (or a capital contribution obligation to the partnership) related to the liability. A constructive liquidation is the hypothetical situation where the partnership’s recourse debts become due and all assets are deemed worthless (also known as the “atom bomb test”).

A partner also bears the EROL if the partner or a related party 1) is the lender on a nonrecourse loan for which no other partner bears the EROL, 2) guarantees interest payments on a partnership nonrecourse debt, or 3) pledges property as security for a partnership debt.

The new final regulations modify or clarify the application of Sec. 752 in three important areas, discussed below.

Overlapping EROL

The final regulations retain the proposed regulations’ so-called “proportionality rule” for determining how partners share a liability when multiple partners bear the EROL for it. The rule provides that a partner’s EROL is calculated as follows:

The amount of the liability x (The amount of the partner’s individual EROL/The total EROL borne by all partners for the liability)

Assume, for example, that unrelated partners A and B both guarantee the partnership’s $1,000 liability; A guarantees the full $1,000, while B guarantees $500. The total EROL ($1,500) exceeds the liability so the partnership will allocate the liability as follows:

Partner A: $1,000 x ($1,000/$1,500) = $667

Partner B: $1,000 x ($500/$1,500) = $333

Notably, the IRS declined to allocate the liabilities based on a partner’s interest in partnership profits.

Tiered Partnerships

Under the proposed rules, an upper-tier partnership (UTP) bears the EROL for a lower-tier partnership’s (LTP’s) liability to the extent that the UTP or a UTP partner bears EROL for the liability. The final regulations clarify the allocation of an LTP’s recourse liabilities to a UTP when a UTP partner has EROL for such liability.

They generally require that the LTP allocate the UTP’s share and the partner’s share of the liability to the UTP, with the UTP then allocating its share directly to any of its partners with EROL for the LTP liability. However, if a partner in the UTP also is a partner of the LTP and bears the EROL for the LTP’s liability, the regulations provide that the LTP must allocate the liability directly to the partner to the extent it bears the EROL.

Related Parties

As indicated above, a partner generally is considered to bear the EROL if a related party bears such risk. The final regulations adopt the proposed regulations’ “related party” exception and “multiple partner rule” for assessing relatedness.

The related party exception applies when a person who owns (directly or indirectly through one or more partnerships) an interest in a partnership has the EROL for a partnership liability. In such a case, other persons who own interests (directly or indirectly through one or more partnerships) in the partnership would not be treated as related to that person for purposes of determining the EROL borne by each of them for the partnership liability.

As laid out in the proposed regulations, the multiple partner rule provides that, when a person has the EROL for a partnership liability and is related to more than one partner, those related partners share the liability equally. The final regulations, however, provide that the related partners are treated as bearing the EROL for the partnership liability in proportion to each related partner’s interest in partnership profits.

The final regulations also require that two “constructive ownership” scenarios be disregarded when determining relatedness. Specifically, if a UTP has an interest in an LTP or in a corporate subsidiary — and the LTP or subsidiary has the EROL for a UTP liability — the UTP partners do not bear the EROL for the liability. The preamble to the regulations explains that a partner should not be treated as bearing the EROL when the partner’s risk is limited to its equity investment in the partnership.

Effective Date

The final regulations generally are effective for liabilities incurred or assumed on or after Dec. 2, 2024. If a liability incurred before Dec. 2, 2024, is refinanced after that date, the regulations apply only to any resulting increase in amount or extension of maturity. Partnerships can opt to apply the regulations to liabilities incurred or assumed before the effective date as long as they do so for all liabilities in a consistent manner

For more information, please contact Tony Salazar at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.

Ownership of Non-U.S. Real Estate Could Have U.S. Tax Consequences

Joshua D. Goldschmidt, CPA, MS., Taxation

It is becoming increasingly common that U.S. citizens and/or residents are acquiring non-U.S. real estate. Whether you obtain foreign real estate as a primary residence, a second home or as an investment opportunity, it is important to consider how the U.S. taxes any associated income, what deductions are available and what reporting is necessary to stay in compliance.

Personal Use Non-U.S. Real Estate

While holding personal use real estate located outside of the U.S. you may be able to claim some deductions but gains on sales could result in tax.

Interest Expense
If the non-U.S. home is either your primary residence or second home and the mortgage is secured acquisition debt (your home is the collateral) then you may be able to deduct the mortgage interest as an itemized deduction as you would with any U.S. mortgage interest. Interest may be limited depending on the amount of outstanding debt, similar to how it is with U.S. mortgage interest.

Foreign Real Property Taxes
As a result of the Tax Cuts Jobs Act (TCJA) of 2017, foreign property taxes are not deductible for 2018 through 2025.[1]

Sales
Selling foreign personal use real estate that results in a gain will be taxable to U.S. citizens and/or residents unless an exclusion applies. One potential exclusion that may apply, is the primary residence exclusion under IRC Section 121. This section is still applicable to foreign property as long as all the requirements are met. You qualify for the exclusion if during the 5-year period before the sale, you owned and used the property as your principal residence for 2 years or more and you did not already claim this exclusion on a different property in the preceding 2 years. The 2-year use requirement is in aggregate and doesn’t have to be consecutive. If you qualify, you can exclude up to $250,000 of gains if filing as single and $500,000 of gains if married and filing joint. Please note that even if you can exclude the entire gain under these rules, it still should be reported on your tax return. If you sell personal use real estate at a loss, the loss will not be deductible.

Non-U.S. Rental Properties

Foreign real estate rentals owned by U.S. citizens and/or residents are required to be reported and any net income will be taxed.

Conversion to U.S. Dollars
Income, expenses, and the unadjusted cost basis of assets to depreciate must be reported on your U.S. income tax return in U.S. dollars. The IRS has no official exchange rate. For a single transaction, such as a sale or purchase of foreign real estate, you should use the exchange rate for that day. If you receive income evenly throughout a tax year you can use the yearly average exchange rate.

Basis
Cost basis is based on the original cost paid for the property and each improvement made. U.S. cost basis is not reduced by foreign depreciation claimed. U.S. depreciation claimed will reduce the net basis you have. Basis is important as it is the starting point for the depreciation calculation and is used in calculating any gain or loss on sale.

Depreciation
The Alternative Depreciation System (ADS) must be applied to any tangible property used predominantly outside of the United States.[2] ADS is a straight-line method which typically has longer recovery periods. Residential property subject to ADS that are placed in service in 2018 or after now have a 30-year recovery period (previously 40-year before 2018) as compared to the 27.5-year recovery period for the Modified Accelerated Cost Recovery System (MACRS), which is the standard for U.S. property. Property which are required to be depreciated under ADS are not eligible to claim bonus depreciation.[3]

Qualified Business Income (QBI)
The Qualified Business Income (QBI) deduction in some circumstances may apply to a foreign rental. One of the key pieces will be determining that it qualifies as a trade or business which may be hard to do and involves a facts and circumstances approach.

Foreign Tax Credit

Foreign tax credits are potentially available to claim against foreign net rental income and foreign gains from sales. The maximum credit you can claim is the lesser of what the U.S. tax would have been on that income had it all been only U.S. source or the foreign income taxes you actually paid. While the foreign tax credit can be applied against federal taxes it is important to consider that if the taxpayer is a U.S. resident, resident state taxes could still be owed.

Additionally, instead of claiming a foreign tax credit, if you so choose, you can elect to deduct foreign income taxes on Schedule A as an itemized deduction. The $10,000 state and local tax (SALT) limitation does not apply to foreign income taxes when this election is made.

Specified Foreign Financial Asset

The U.S. has additional requirements for reporting ownership of foreign assets, however foreign real estate owned directly is not considered a specified foreign financial asset for Form 8938 filing purposes. If the real estate is held in any type of foreign entity, then it is considered a foreign financial asset and may result in a Form 8938 filing requirement.

In addition to the Form 8938, there may be other filing requirements if real estate is held in a foreign entity, if it was inherited or a gift was received to purchase it, or if money was transferred to or from the foreign entity in the tax year.  Foreign bank accounts also are a specified foreign financial asset for Form 8938 and could create a FBAR Form 114 filing requirement as well.

Conclusion

The U.S. has complex rules for international tax. To make sure you are not only compliant but also applying the most beneficial strategies for your situation you should discuss with an advisor.

[1] IRC §164(b)(6)(A)

[2] IRC §168(g)(1)

[3] IRC §168(k)(2)(D)

For more information, please contact Joshua Goldschmidt at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.