United States

IRS reverses course on treatment of "bad boy" loan guarantees

TAX ALERT  | 

Many in the real estate industry were shocked at the conclusions reached in a recent IRS memorandum, which held that industry-standard ‘bad boy’ loan guarantee provisions might cause the loans to be treated as recourse debts to the general partners—thus limiting the ability of other investors to deduct losses.   

As previously discussed in detail in our article, Bad boy" guarantees may impact partners’ ability to deduct real estate losses, these guarantees are quite common in real estate transactions and are rarely violated. Tax advisors generally concluded that they were subject to Reg. section 1.752-2(b)(4), which clearly provides that a guarantee should be disregarded if, taking into account all the facts and circumstances, the guarantee is subject to contingencies that make it unlikely that it would ever be triggered.

Many in industry questioned this ruling, and as a direct result, it appears that the IRS has revisited its earlier positon. On April 15, 2016, the IRS issued a new, general ruling including a detailed analysis that clearly holds that these common provisions are clearly within the guidelines of Reg. section 1.752-2(b)(4), and as a result, will not cause a loan to be treated as recourse.

In particular, the IRS explained:

“We understand that including some form of one or more of these “nonrecourse carve-out” provisions in loan agreements is a fairly common practice throughout the commercial real estate finance industry and has been for many years. . . .  [T]he fundamental business purpose behind such carve-outs and the intent of the parties to such agreements is to prevent actions by the borrower or guarantor that could make recovery on the debt, or acquisition of the security underlying the debt upon default, more difficult. The “nonrecourse carve-out” provisions should be interpreted consistent with that purpose and intent in mind. Consequently, because it is not in the economic interest of the borrower or the guarantor to commit the bad acts described in the typical “nonrecourse carve-out” provisions, it is unlikely that the contingency (the bad act) will occur and the contingent payment obligation should be disregarded. . . .”

The typical bad boy guarantees described by the IRS as permitted include guarantees of partnership nonrecourse obligations that only apply if:

  1. The borrower fails to obtain the lender’s consent before obtaining subordinate financing or transfer of the secured property,

  2. The borrower files a voluntary bankruptcy petition,

  3. Any person in control of the borrower files an involuntary bankruptcy petition against the borrower,

  4. Any person in control of the borrower solicits other creditors of the borrower to file an involuntary bankruptcy petition against the borrower,

  5. The borrower consents to or otherwise acquiesces or joins in an involuntary bankruptcy or insolvency proceeding,

  6. Any person in control of the borrower consents to the appointment of a receiver or custodian of assets, or

  7. The borrower makes an assignment for the benefit of creditors, or admits in writing or in any legal proceeding that it is insolvent or unable to pay its debts as they come due.

While this ruling does add needed clarity, real estate partnerships should review their loan agreements to understand the nature of these types of provisions to consider whether they may impact how the debt should be classified and allocated among partners.

 

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