United States: Proposed Section 752 Regulations Would Prohibit Bottom Guarantees And Impose Net Worth Requirements In UPREIT Transactions

Last Updated: March 26 2014
Article by Joan M. Roll and Timothy J. Leska

The IRS has recently proposed regulations under Section 752 of the Code which, if finalized in current form, would radically change the use of guarantees in partnership transactions.1 Under these regulations, bottom guarantees would no longer be effective for tax deferral, and guarantors would have to meet stringent new net worth requirements. The regulations would have far-reaching consequences to many partnership transactions and are particularly relevant to REITs because they would eliminate customary approaches to structuring tax-deferred contributions of property.

UPREIT Transactions – Current Practices

Many REITs have adopted a partnership structure, referred to as an "UPREIT" or "umbrella" partnership, in which all of the REIT's properties are held through a majority-owned partnership subsidiary. The UPREIT structure facilitates property acquisitions by providing a partnership vehicle into which property owners can contribute property on a tax-deferred basis. In contrast, a contribution of property directly to a REIT in exchange for REIT shares would be immediately taxable. The units of the UPREIT partnership are designed to have substantially the same economic entitlements as a share of the REIT. In addition, the units typically are exchangeable for REIT shares at the option of the holder (after a specified period), a feature that provides the unitholder with the opportunity for future liquidity.

Guarantees are used in UPREIT transactions to protect property contributors against immediate taxation when property is contributed to the UPREIT. For example, a contributor with a negative capital account can have taxable income as a result of the contribution, unless the contributor receives an allocation of partnership liabilities sufficient to cover the amount of the negative capital account. Entering into a guarantee of partnership debt is one way to receive such an allocation. Guarantees are also used to allow a property contributor to receive cash in a "debt-financed distribution," provided that the cash is traceable to a debt that the partner has guaranteed.2 So-called "bottom" guarantees have been particularly attractive to property contributors because they limit the amount of risk the guarantor must assume. Under a "bottom" guaranty, the guarantor effectively guarantees only the "last" dollars owed to the lender under a loan.

Example: A partnership owning a single parcel of real estate worth $120 million borrows $100 million under a nonrecourse loan. Partner A enters into a bottom guaranty of the loan in the amount of $20 million. Partner A will only have to make a payment to the lender if the partnership defaults and the lender realizes less than $20 million from the collateral. In this example, the bottom guarantor would only be called upon to pay if the real estate declines in value by more than $100 million.

Under regulations that have been in place since 1992,3 bottom guarantees are effective for tax purposes. Currently, the regulations allocate economic risk of loss for a partnership liability based on a worst-case scenario in which all partnership debts become due, all partnership assets are worthless, and each partner is presumed to satisfy its payment obligations under applicable law and contractual agreements. In the example above, under the worst-case scenario the real estate is considered to be worth zero, the debt of $100 million is due, the lender would receive nothing by foreclosing on the real estate, and Partner A would have to pay the lender the full amount of the $20 million guarantee. Under the existing regulations, Partner A would be allocated $20 million of the liability for tax purposes, subject to an anti-abuse rule. The anti-abuse rule applies when the facts and circumstances indicate a plan to avoid the obligations under the guarantee (such as a guarantee given by a thinly capitalized guarantor).4

New Rules for Guarantees under the Proposed Regulations

The Proposed Regulations would make sweeping changes to the existing rules for allocation of partnership liabilities. These changes result from concern by the IRS and the Treasury Department that some partners have entered into guarantees that are "not commercial" solely to achieve an allocation of a partnership liability for tax purposes. The proposed rules, if adopted, would constrain tax-motivated guarantee arrangements by requiring guarantees to contain specified "commercially reasonable" provisions and by imposing new net worth requirements on guarantors.

Six-Factor Test for Commercial Reasonableness

The proposed regulations set forth six criteria that must be met if a guaranty is to be respected. These criteria are intended to ensure that the terms of a guaranty are commercially reasonable and not designed solely to obtain tax benefits. All six of the following requirements must be satisfied:

  • the Guaranty requires the guarantor to maintain a commercially reasonable net worth throughout the term of the guarantee or subjects the guarantor to commercially reasonable contractual restrictions on transfers of assets for inadequate consideration
  • the Guaranty requires the guarantor periodically to provide commercially reasonable documentation regarding its financial condition
  • the Guaranty does not end prior to the term of the partnership liability
  • the Guaranty does not require that the partnership directly or indirectly hold money or other liquid assets in an amount that exceeds the reasonable needs of the partnership
  • the guarantor receives an arm's-length fee for making the guaranty, and
  • the guarantor is liable up to the full amount of the guaranty, if and to the extent that any amount of the partnership liability is not otherwise satisfied (eliminates "bottom guarantees").

Net worth Requirements

Under the Proposed Regulations, partners (other than individuals or decedent's estates) would have to satisfy a net value requirement. A partner's guaranty would only be respected to the extent of the partner's net value (excluding the value of the partnership interest). Thus, if a partner guarantees $20 million of a $100 million loan, the partner must have a net worth of $20 million in order for the guaranty to be fully respected. If the partner's net worth is only $5 million, then the guaranty would only be respected to the extent of $5 million. Partners would also be subject to a requirement to provide information as to their net worth to the partnership on a timely basis.

Pepper Perspective

Application to Future Transactions

The Proposed Regulations, if and when finalized, would pose significant barriers to structuring tax-deferred UPREIT transactions. Property contributors may be unwilling to guarantee debt without the protections against risk previously available using bottom guarantees, and may be unwilling or unable to satisfy the net value requirements. Further, a new anti-abuse rule would limit structuring to avoid the impact of the rules by using tiered partnerships or multiple tranches of liabilities to achieve the same effect as a bottom guarantee. UPREIT partnerships would have to pay arm's-length fees to guarantors and periodically monitor their financial condition. As a result, UPREIT transactions may become less attractive than in the past. REITs entering into tax protection agreements with property contributors should consider the future impact of the Proposed Regulations with respect to the required provisions of guarantees and contributor net worth reporting requirements.

Effect on Existing Transactions and Guarantees

The Proposed Regulations are not proposed to be retroactive, so the six-factor test for guarantees and the net value requirements would only apply to guarantees entered into on or after the date the regulations become final or pursuant to a binding contract entered into prior to that date. Importantly, the Proposed Regulations provide a transitional rule under which the existing regulations can be applied for a seven-year period to partners with existing debt guarantees, up to a "grandfathered amount" equal to the partner's negative capital account at the time the regulations are finalized, subject to certain adjustments. Thus, partners with existing grandfathered amounts could continue to enter into new bottom guarantees during the seven-year transition period (for instance, as existing guaranteed loans are refinanced) and would not be required to satisfy the net worth requirement during this period. REITs who have entered into tax protection agreements with property contributors should review existing contractual obligations to determine how the Proposed Regulations and transitional rules would impact their continuing obligations to provide contributors the opportunity to guarantee debt.

Footnotes

1 REG-119305-11 (January 29, 2014). References to "Code" refer to the Internal Revenue Code of 1986, as amended. References to "Section" refer to Sections of the Code.

2 Treasury Regulation Section 1.707-5(b).

3 Treasury Regulation Section 1.752-2.

4 Treasury Regulation Section 1.752-2(j). See Canal Corp. vs. Commissioner, 135 T.C.199 (2010).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Joan M. Roll
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions