United States

"Bad boy" guarantees may impact partners’ ability to deduct real estate losses

INSIGHT ARTICLE  | 

UPDATE: The IRS has reversed previous guidance that would have adversely affected real estate investments using nonrecourse financing. See our April 18, 2016, article,  IRS reverses course on treatment of "bad boy" loan guarantees.


In a surprising internal legal memorandum, certain officials in the IRS national office concluded that so called ‘bad boy’ provisions, commonly included in many real estate transactions, could limit tax deductions for certain partners. Such provisions theoretically shift the risk of non-payment on nonrecourse debt, but only in the event of certain remote contingencies that are generally within the control of the parties. For that reason, most practitioners view them as contingencies that can be disregarded under applicable IRS regulations, allowing the nonrecourse debt to be allocated in proportion to the partners’ interests in the partnership and providing tax basis to the partners that allows them to deduct their share of partnership losses. If the contrary position taken in this internal memorandum truly reflects the IRS position, many partnerships may need to review and potentially revise existing agreements with regard to nonrecourse debt.

In a typical real estate partnership, qualified nonrecourse debt will be allocated among all partners and will provide at-risk basis for those partners to deduct losses. In contrast, recourse debt will typically only be allocated to the guaranteeing partner, leaving the other partners with no debt allocation to support a loss allocation. If notionally nonrecourse debt is guaranteed by one partner, it loses its status as nonrecourse debt, and the other partners may lose valuable deductions. In some cases, of course, real estate partnerships that utilize third-party financing are required to provide bona fide guarantees by one or more of the individual partners, making the debt into recourse debt. In other cases, the lender is willing to lend solely on the basis of the underlying real estate. Even in such cases, however, loan agreements will often contain bad boy provisions, promises by the borrower not to engage in certain extreme behavior. Common examples include (but are not limited to) waste, fraud, misappropriation of funds, and the filing of a voluntary bankruptcy petition. To give teeth to those commitments, engaging in such behavior typically results in a third party (usually one of the partners) becoming a partial or full guarantor on the underlying debt. 

Although these provisions are common, they are rarely violated. As a consequence, real estate partnerships and their tax advisors typically disregard these provisions when determining whether the related debt is considered to be recourse or nonrecourse with respect to its partners. Indeed, if a taxpayer inserted such a provision wishing it to be recognized by the IRS, in order to shift liabilities and tax basis to a party that did not truly bear any economic risk, the IRS would almost certainly argue that the provision should be disregarded because it is completely within the purported obligor’s ability to control whether they breach their own promises. IRS regulations expressly provide that such “paper” promises should be disregarded.  Taxpayers may recall a successful attack by the IRS on a so-called “leveraged partnership” in Canal v. Commissioner where the IRS asserted that a purported guarantee by the holder of a preferred partnership interest should be disregarded because there was no realistic intention or probability that the guarantee would result in any payments by the purported guarantor.  As a result, in that case, the preferred partner was treated as having sold property contributed to the partnership in a disguised sale, because the recourse liability it claimed to retain, under the guarantee, was properly disregarded.

In this particular memorandum, the IRS considered a nonrecourse loan agreement that provided that a particular partner would become a guarantor if any of the following are met:

  • The borrower failed to obtain the lender's consent before obtaining subordinate financing or transferring the secured property
  • The borrower filed a voluntary bankruptcy petition
  • Any person in control of the borrower filed an involuntary bankruptcy petition against the borrower
  • Any person in control of the borrower solicited other creditors to file an involuntary bankruptcy petition against the  borrower
  • The borrower consented to or otherwise acquiesced or joined in an involuntary bankruptcy or insolvency proceeding
  • Any person in control of the borrower consented to the appointment of a receiver or custodian of assets
  • The borrower made an assignment for the benefit of creditors, or admitted in writing or in any legal proceeding that it was insolvent or unable to pay its debts as they came due

The taxpayer concluded that these bad boy provisions could be ignored based on language in section 1.752-2(b)(4) that so provides in circumstances where an obligation is subject to contingencies that make it unlikely that the obligation will ever be discharged. The IRS disagreed, finding that the likelihood that the taxpayer would ever trip one of these provisions was not so remote as to be considered "likely to never be discharged" within the meaning of section 1.752-2(b)(4). As a consequence, the IRS concluded that the debt was recourse, entirely allocable to the guarantor.

This ruling surprised many practitioners who believed (and likely continue to believe) that bad boy provisions often should be ignored pursuant to section 1.752-2(b)(4) until such time as there is more than a remote possibility that they would be triggered. Nonetheless, this ruling makes it clear that 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, and whether a reallocation might impact partners’ ability to deduct losses that might otherwise be allocated to them.

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