Section 752 Regs Don't Determine If Debt Is Recourse or Nonrecourse When Characterizing Income on Foreclosure.

(Parker Tax Publishing July 14, 2015)

The regulations under Code Sec. 752 do not determine if a debt is recourse or nonrecourse to a partnership for purposes of determining whether, upon foreclosure of property purchased by the partnership, the partnership has cancellation of debt income under Code Sec. 61(a)(12) or gains from dealings in property under Code Sec. 61(a)(3). CCA 201525010.

Background

A limited liability company (LLC), taxable as a partnership, was organized to purchase real property and then construct, market, and sell homes built on that property. LLC has three members: two individuals and an S corporation. LLC's operating agreement provides that LLC is a special purpose entity (SPE) (1) organized solely for the purpose of owning the property, (2) that will not engage in any business unrelated to the ownership of the property, and (3) that will not have any assets other than those related to the property.

One of LLC's lenders cancelled outstanding notes created in connection with loans made by that lender to LLC in order to develop the real property. The notes were secured by (1) the property; (2) a general assignment of LLC's rights, title, and interest in and to the property; (3) a general assignment of members' rights, title, and interest in and to the property; (4) pledges of the membership interests in LLC by the members; and (5) unlimited, unconditional, and irrevocable guarantees by each LLC member.

LLC reported the income from the discharge of indebtedness on its Schedule K as cancellation of debt (COD) income, which was allocated to LLC members on their respective Schedules K-1. The LLC members were insolvent. To the extent of their reported insolvencies, the LLC members in the aggregate excluded amounts from gross income under Code Sec. 108(a)(1)(B), and eliminated net operating loss amounts pursuant to the tax attributes reduction rules of Code Sec. 108(b). As a result, the LLC members will receive a permanent tax benefit of a portion of excluded COD, which was passed through to them from LLC.

Upon auditing LLC, an IRS agent raised the issue of whether this COD income should be reclassified as an amount realized from a sale or other disposition of property under Code Sec. 61(a)(3). The agent reasoned that, pursuant to Reg. Sec. 1.1001-2(a)(1) and (4)(i), if debt that is discharged in connection with the sale or other disposition of property is nonrecourse to the borrower, the full amount of the discharged debt is included in the amount realized, and thus the transaction results in gain or loss. One result of this reclassification at the partnership level is that LLC's members will be unable to exclude part of the income under Code Sec. 108 at the partner level.

LLC countered that the regulations under Code Sec. 752 determine whether a loan to a partnership is recourse or nonrecourse for Code Sec. 1001 purposes. According to LLC, the notes are recourse loans because its members are personally liable for repayment under the guaranty agreements. LLC argued that its members' guarantees are payment obligations under Reg. Sec. 1.752-2(b)(3)(i) that represent an economic risk of loss to its members, and, as a result, the notes meet the definition of "recourse" loans under Reg. Secs. 1.752-1(a)(1) and 1.752-2.

Analysis

The IRS Office of Chief Counsel (IRS) advised that the regulations under Code Sec. 752 do not determine if a debt is recourse or nonrecourse to a partnership for purposes of determining whether, upon foreclosure of the property, the partnership has cancellation of debt income under Code Sec. 61(a)(12) or gains from dealings in property under Code Sec. 61(a)(3).

The IRS noted that the regulations under Code Sec. 752 are limited to determining the partners' basis in the partnership. The definition of a recourse liability found in Reg. Sec. 1.752-1(a)(1), the IRS stated, is limited to issues under Code Sec. 752, rather than a definition intended to extend to issues under Code Secs. 61 and 1001.

In the instant case, the IRS said, the operating documents and the loan documents, as well as the LLC's status as an SPE, expressly limited LLC's assets to those related to developing the property, a single project. According to the IRS, any and all assets (including future leases, rents and fixtures) held by LLC necessarily relate to the property, and thus secure the notes. Since LLC was not authorized to acquire other assets, the IRS noted, the operating documents and loan documents stop short of imposing full, unconditional, personal liability on LLC for repayment of the notes. The IRS concluded that the lenders, therefore, had no further recourse against LLC once the property and the assets related to the property were exhausted when the lender foreclosed on the property.

For a discussion of the characterization of partnership liabilities as recourse or nonrecourse, see Parker Tax, ¶25,115, and ¶25,125, respectively. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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