GRC Memorandum on Qualified Nonrecourse Financing and Regulations
TO: Government Relations Committee
FROM: Tony M. Edwards
DATE: August 7, 1998
RE: Success with the "at risk" regulations
You may recall that almost exactly a year ago, the Internal Revenue Service ("IRS") published proposed regulations meant to liberalize the application of the antiquated "at risk" rules. While the at risk provisions limit a taxpayer's ability to offset losses against other sources of income, the more important issue to partners in UPREITs and DownREITs generally is the requirement to have a positive basis for at-risk purposes in addition to a maintaining positive basis in his partnership interest. A partner can include qualified nonrecourse indebtedness in his at-risk basis.
Gary Cutson of PricewaterhouseCoopers chaired a task force to prepare a detailed submission, and we received helpful comments from Bill Bonn of Beacon Capital Partners, Jamie Canup of McGuire Woods, Prentiss Feagles of Hogan & Hartson, Mike Frankel of PricewaterhouseCoopers, Art Greenberg of Equity Group Investments and Lary Wolf of Roberts & Holland. The full submission (dated November 18) is found in the legal/legislative area of NAREIT's members only section at www.nareit.com.
On August 3, 1998, the IRS released final regulations on the definition of "qualified nonrecourse indebtedness" under the at-risk provisions. I am pleased to report that the IRS acted favorably on NAREIT's comments in finalizing the regulations, and thanks again to Gary Cutson, who substantially prepared the below summary of the final regulations. We are grateful to the Treasury Department and the IRS for adopting more flexible rules in this area. Note that NAREIT supports the repeal of the "at risk" rules as they apply to real estate because they were rendered obsolete and duplicative when Congress enacted the passive loss rules in 1986.
* The final regulations clarify the concept of "secured by real property." Agreeing with NAREIT's comments, the regulations do not require a mortgage on the property.
* NAREIT suggested that qualified nonrecourse financing should be able to be secured by additional personal property, rather than "solely" by real property (and incidental personal property), as possibly suggested by legislative history. Under the final regulations, the partnership can hold up to 10% of the value of its gross assets in personal property beyond personal property which is incidental to holding real property. In many cases, the 10% allowance will be adequate, but partnerships may have to be careful about taking back notes from the sale of properties.
* The proposed regulations would have been effective for financing incurred on or after the date the final regulations were published in the Federal Register, and NAREIT asked for an elective effective date. While the final regulations apply to financing incurred on or after August 4, 1998, the taxpayer can elect to apply them to existing debt. The regulations do not specify whether the partnership or the partner makes that election or how it is made. Presumably, the partnership will make it since the partnership classifies the liabilities on the Schedule K-1s.
* As requested by NAREIT, the final regulations apply a look-through approach to ownership of lower tier partnerships.
* If debt is partially guaranteed by a person other than the partnership, the nonrecourse portion may qualify. The regulations permit multiple partnerships to be liable if the partnerships are the only persons that are liable.
The definition of a "qualified lender" remains a significant issue in meeting the requirements for qualified nonrecourse debt in public debt offerings. (The issue was beyond the scope of these regulations.) Among other things, a qualified lender must be "regularly and actively engaged in the business of lending money." The IRS released private letter rulings earlier this year ruling favorably on the issue where the offering was made through underwriters who sold the debt to investors who were qualified lenders. The partnership committed to register the debt within 135 days of issuance. Prior to registration the debt was generally restricted to transfer to other qualified lenders. After registration, the restrictions expired. See PLRs 9815001 (November 6, 1997) and 9815022 (December 23, 1997).