A partner’s tax basis in a partnership determines, among other tax consequences, the amount of partnership losses the partner may deduct as well as the amount of partnership distributions the partner may receive without triggering taxable gain. A partner’s tax basis includes not only the amount of the partner’s investment (which is adjusted for partnership income and loss allocations and other items as required under the tax code), a partner’s tax basis also includes the partner’s share of partnership liabilities.
“Bottom-dollar guarantees” were a common technique used in many real estate transactions as a way for partners to increase their allocations of partnership liabilities while limiting their risk. However, final regulations published in October 2019 generally put an end to the use of bottom-dollar guarantees as a means of bolstering tax basis in a partnership interest on debt incurred after October 5, 2016, unless special transition rules applied. Taxpayers are reminded that the special transition rules will expire and the final regulations will become fully effective on October 4, 2023. Importantly, while the end of bottom-dollar guarantees serves as the final nail in the coffin of the use of non-economic arrangements to increase partnership tax basis, the rules providing tax basis for partnership liabilities are alive and well. Taxpayers can continue to work within these rules to ensure, to the extent possible, that they have sufficient tax basis to protect against current taxation of distributions or prevent basis-driven loss limitations.
BDO Insights
Bottom-dollar guarantees have historically been used in carryover basis real estate transactions such as UPREITs and DownREITs where low basis real estate is contributed to a partnership. Because partnership liability basis in these types of transactions may be the only protection the owners have against current taxation, maintaining a certain level of liability allocation can be key to continued tax deferral. As the final demise of bottom-dollar guarantees looms, both partners and partnerships should review existing and future planned partnership liability allocations as well as available opportunities to maximize tax deferral and minimize the overall effect of the final regulations.
Partnership Liability Basis
A partner’s tax basis in a partnership is increased by the amount of the partner’s allocable share of partnership liabilities. Partnership liabilities can either be (i) recourse, to the extent a partner bears an economic risk of loss in the event of a partnership default; or (ii) nonrecourse, to the extent that no partner bears a risk of loss, for example, a liability that is secured by a pledged asset with no ability of the lender to collect any deficiencies from the partnership or its partners. Recourse liabilities are allocated to the partners that bear the economic risk of loss; nonrecourse liabilities are allocated to all partners, generally based on how they share profits.
Recourse and nonrecourse liability basis permits a partner to receive cash distributions in excess of their investment in the partnership (up to the amount of the liability basis) without triggering taxable gain. In addition, recourse (but only certain nonrecourse) liability basis is considered “at-risk” basis that a partner may use to deduct allocated partnership taxable losses. Traditionally, bottom-dollar guarantees were used to create additional recourse liability basis for the guarantor partner.
Bottom-Dollar Guarantees and the 2019 Final Regulations
Prior to the 2019 final regulations, bottom-dollar guarantees were perceived as a way for partners to obtain recourse liability tax basis in a partnership while limiting their economic risk. A bottom-dollar guarantee is a guarantee by a partner of an amount of partnership debt, where the partner pays only if the creditor collects less than the full amount of the debt from the partnership. Further, in a bottom-dollar guarantee, even if the creditor does not collect the full amount of the debt, the bottom-dollar guarantor pays nothing provided the creditor collects at least the amount of the bottom-dollar payment obligation.
The 2019 final regulations reflect the government’s view that bottom-dollar guarantees do not create a meaningful economic risk of loss for the guarantor partner, because they are structured so that there is little likelihood that the guarantor will have to satisfy any part of the guarantee. As such, the final regulations provide that bottom-dollar payment obligations may not be considered in determining the partner’s share of recourse partnership liabilities for purposes of calculating tax basis.
End of Transition Rules
Under the final regulations’ transition rules, bottom-dollar guarantees:
Are ignored for new debt incurred after October 5, 2016 that is not subject to a written binding contract in effect prior to that date; but
May temporarily continue to create tax basis for debt existing on October 5, 2016, to the extent the basis associated with the allocation of liabilities in connection with the bottom-dollar guarantee under the old rules protected a negative capital account prior to that date.
The transition rules are effective only for the seven-year period that ends on October 4, 2023. With the end of the seven-year transition period less than two years away, taxpayers that currently rely on bottom-dollar guarantees for partnership tax basis should begin to consider their options.