United States: Mr. Irresistible Force, Meet Ms. Immovable Object

In the acquisition and financing of income-producing property, there are usually three parties at the table:  the sponsor (often a local entrepreneur who has located and will manage and lease the building), the equity investor (often an institution, such as a life company, real estate fund or REIT) and the lender.

In closing the equity and debt, the sponsor functions as a tiny fulcrum balancing a teeter totter board with an elephant on one end and a hippo on the other, neither of whom wants to stay balanced with the other.  As if the fulcrum’s job wasn’t already hard, a recent Memorandum from the Office of Chief Counsel of the IRS potentially up-ends one of the traditional risk allocation and tax benefit analyses that makes real estate investments appealing to equity investors in the first place.

A compelling benefit for institutional investors investing in improved real estate is the potential for recognizing taxable losses in excess of the amount invested.  Real estate owners (usually limited liability companies – pass-through entities – in which the members are the sponsor and the equity investor) are able to include debt encumbering the real estate as part of the owner’s (practically, the LLC members’) tax bases.  Generally, the rule is (or has been) that an owner may include the debt as part of his taxable basis (i) to the extent it is personally liable for repayment or (ii) to the extent that no one is personally liable (that is, the lender’s only recourse for nonpayment is to foreclose on the property; a so-called “non-recourse” loan).  The IRS’s General Counsel Memorandum (number 201606027), released February 5, 2016, potentially redefines non-recourse loans for purposes of computing tax basis.  The Memorandum indicates that, when a sponsor signs a “springing recourse” guaranty in the context of a non-recourse loan, the institutional investor can no longer take advantage of taxable losses in excess of its investment – because the sponsor’s “springing recourse” guaranty functions as a “payment guaranty” that effectively shifts all the debt into the tax basis for the sponsor signing the guaranty.  The Memorandum further provides that a capital call provision in favor of the guaranteeing member on the other members for reimbursement may not be sufficient to shift the basis back to the other members.  The Memorandum’s conclusions upset long-standing assumptions about how traditional non-recourse loan structures affect borrower members’ tax treatment.

To illustrate how the debt/basis rules work in a typical LLC structure, assume that AB, LLC has two members, the Sponsor (who invests $30 of equity) and the Investor (who invests $270 of equity).  Sponsor and Investor share profits and loss on a 10/90% ratio.  AB, LLC borrows $700 from Scrooge & Marley Bank, N.A. (“Bank”) and combines it with the equity to buy income producing real estate.  Bank requires the Sponsor to guaranty the repayment of the loan.  For tax basis purposes, Sponsor’s guaranty results in Sponsor’s basis being $730 ($700 + $30) and the Investor’s being $270.  As such, Sponsor will be able to recognize more tax losses than Investor.  This is not what Investor wants, but Investor doesn’t want to guarantee the loan either.  What the Investor wants is for no one to be liable for repayment – that is, under the long-held analysis of the tax regulations, in order to make the investment attractive for the Sponsor, Sponsor would prefer the property be financed via a non-recourse loan.  If the loan from the Bank is non-recourse, then Sponsor and Investor share the debt basis on a 10/90 basis such that Sponsor’s basis is $100 ($30 + $70) and Investor’s is $900 ($270 + $630).

The use of non-recourse loans is standard practice for ventures investing in income-producing properties. When lenders agree to non-recourse debt, however, they still want to protect themselves from waste, fraud and similar acts committed by borrowers (typically referred to as “bad boy/bad girl” acts).  This protection is provided by a “non-recourse carve out guaranty” that is usually signed by the sponsor only.  This sort of guaranty is not relevant for basis allocation.  The guaranty is not a guaranty by Sponsor to repay the loan in the event of a bad boy act; it is an agreement to be responsible only for any damages that the Bank suffers as a result of the bad acts of the property owner. 

However, in addition to non-recourse carve-out guaranties, non-recourse lenders also require creditworthy members of a borrower to execute “springing recourse” guaranties.  “Springing recourse” guaranties provide that if the borrower files for bankruptcy, then the springing recourse guarantors become liable for the full repayment of principal and interest on the loan.  Most practitioners have not traditionally seen sponsors’ “springing recourse” guaranties as shifting the tax basis arising from a loan to the sponsor and away from the institutional investor.  Historically, the IRS rules seemed clear that guaranties subject to contingencies that were unlikely to occur (like causing a borrower to file for bankruptcy if that would subject one to personal liability for a debt) would not turn an otherwise non-recourse debt into a recourse one.  This risk was further mitigated by provisions of many LLC agreements which allowed a member, who paid the principal of any LLC debt, to make a capital call on the non-guaranteeing members to, in turn, reimburse the paying member for its pro rata share of the debt.  Such a provision would have the effect of making all members liable, at least indirectly, for the debt, thereby resulting in them retaining a pro rata share of the debt as part of their basis. 

Memorandum 201606027 upsets these assumptions.  The Memorandum is not precedential, but some practitioners are concerned that this may be a warning of a more aggressive position by the IRS on this point.  The logic of the Memorandum has been criticized by many commentators.  It seems to ignore both express provisions of existing regulations (or explains those provisions away in a half-hearted manner) and the realities of modern real estate finance risk allocation.  Nonetheless, institutional investors are starting to take notice.  We can expect to see lenders insisting on standard springing recourse provisions for bankruptcy to be imposed on sponsors, sponsors being willing to undertake that risk (as has been the custom) and institutional equity investors insisting on eliminating those provisions, posing yet one more challenge to sponsors trying to close transactions with large financial players who have clear conflicting positions.

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.

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