Proposed Disguised-Sale Regs. Offer Clarification and Issues for Real Estate

By Anthony S. Bakale, CPA, MT, and Angelina Milo, CPA, Cleveland

Editor: Anthony S. Bakale, CPA, M.Tax

Partners & Partnerships

On Jan. 30, 2014, the Treasury Department issued new proposed regulations (REG-119305-11) intended to clarify the disguised-sale rules under Sec. 707 and the allocation of partnership liabilities under Sec. 752.

The existing final regulations under Sec. 707(a)(2) relating to disguised sales of property to and by partnerships were issued in 1992. In 2004, Treasury issued proposed regulations relating to disguised sales of partnership interests, but these were withdrawn in 2009. Treasury has not yet issued revised rules regarding disguised sales of partnership interests. However, the proposed regulations issued on Jan. 30, 2014, address concerns Treasury raised in the preamble to the 2004 proposed regulations. The following is a summary of the new proposed rules covering these concerns.

Under existing Regs. Sec. 1.707-3, a transfer of property to a partnership by a partner followed by a distribution of money or other consideration to the transferee will be treated as a sale of property by the transferee partner to the partnership if, based on all the facts and circumstances, the distribution by the partnership would not have occurred but for the transfer of the property by the transferee partner. Notwithstanding this general rule, the existing regulations contain several exceptions.

Debt-Financed Distribution Exception

Under the existing regulations, a distribution of money to a partner that is directly traceable to a partnership borrowing (incurred within 90 days of the distribution) will not be taken into account to the extent the borrowing does not exceed the transferee partner's share of the liability. The proposed regulations not only include an ordering rule, which applies the exception for debt-financed distributions before applying certain other exceptions to the disguised-sale rules, but also add an example to illustrate the debt-financed-distribution exception under the existing regulations when more than one partner receives all or a portion of the debt proceeds of multiple liabilities.

Under the debt-­financed-­distribution exception, if the partnership makes distributions under a plan to one or more partners from the proceeds of one or more liabilities, the exception treats all liabilities incurred as a single borrowing. In Prop. Regs. Sec. 1.707-5(g), Example (12), O transfers property X , and P transfers property Y , to OP Partnership. Subsequently, the partnership incurs two liabilities, Liability 1 of $8,000 and Liability 2 of $4,000. The partnership makes a distribution to O and P of $2,000 each. The distributions under Temp. Regs. Sec. 1.163-8T are traceable to either Liability 1 or Liability 2, previously incurred by OP Partnership. The liabilities are recourse liability of the partnership and are allocable to the partners pro rata, $4,000 and $2,000, respectively. In the example, Liability 1 and Liability 2 are treated as a single liability allocated $6,000 each to the partners.

For purposes of the exception, each partner's share of the liability is multiplied by a fraction, the numerator of which is the amount of the distribution traceable to the liability incurred and the denominator of which is the total liability incurred. Therefore, $2,000 ([$4,000 ÷ $12,000] × $6,000) of the distribution is treated as being debt-financed and excepted from the transfer rule. This amount is deducted from the total distributions received by O and P to determine the amount subject to the rules of Regs. Sec. 1.707-3. The total transfer to each partner of $2,000 less the debt-financed amount of $2,000 equals $0 and is considered to be proceeds in a disguised sale of property to the partnership. Obviously, this example is overly simplified, but it provides a bright-line calculation to determine the amount to be taken into account in much more complex situations.

Preformation Expenditures

Another existing exception to the disguised-sale rules is for reimbursements of preformation expenditures (Regs. Sec. 1.707-4(d)). Under this exception, to the extent amounts distributed (transferred) by the partnership to the transferee represent reimbursement of certain capital expenditures incurred by the transferee partner during the 24-month period prior to the transfer, these amounts are excepted from the rules of Regs. Sec. 1.707-3. The proposed regulations address three issues related to the preformation expenditure exception. First is the transfer of multiple properties. Generally, the exception applies only if the reimbursement does not exceed 20% of the fair market value (FMV) of the property transferred. And the 20% limitation does not apply if the FMV does not exceed 120% of the transferee's cost basis in the property transferred. In the case of a transfer of multiple properties, the proposed regulations clarify that the 20% limitation and the 120% appreciation exception to the limitation apply on a property-by-property basis. Therefore, where multiple properties are transferred, a partner and partnership will need to test each property transferred to determine to what extent amounts may be excluded.

Second, the proposed regulations clarify the term "capital expenditures." For purposes of the disguised-sale rules, this term has the same meaning as that used elsewhere in the Code and regulations (e.g., Sec. 263), except that capital expenditures include amounts the taxpayer has elected to deduct (e.g., Secs. 179 and 174) and does not include deductible expenditures the taxpayer has elected to capitalize (e.g., Sec. 266).

Third, the proposed regulations aim to prevent double-counting certain capitalized expenditures that are debt-financed. Under Regs. Sec. 1.707-5, amounts transferred to the transferee of property do not include certain liabilities that are assumed or property taken subject to the liabilities that meet one of four definitions of qualified liabilities under Regs. Sec. 1.707-5(a)(6). One of these qualified liabilities is a liability that is traceable under Temp. Regs. Sec. 1.163-8T to a capital expenditure with respect to the property transferred. The proposed regulations clarify that the exception for the reimbursement of capital expenditures does not include capital expenditures that were debt-financed where the debt financing is assumed by the recipient of the property and is a qualified liability.

Anticipated Reduction in Liabilities

Under existing regulations, the partner's share of a liability that is assumed, or property taken subject to the liability, is determined by taking into account certain reductions in the partner's allocable share of such liabilities subsequent to the transfer of property (the anticipated-reduction rule). The proposed regulations clarify that this rule will not apply to the extent that the reduction in the liability is subject to the entrepreneurial risk of the partnership's operations. These rules can best be understood by way of example.

Example: A partner owns a piece of property. Within a short time prior to the transfer of this property to the partnership, the partner incurs a debt on the property and retains cash from the proceeds. The debt is guaranteed by the partner. The partner subsequently transfers the property to the partnership subject to the debt, and the partner continues his guarantee of the debt.

Since the partner continues to be liable for the debt, it is not considered to be an amount transferred to the partner under the disguised-sale rules. However, if the partnership subsequently refinances the debt and relieves the partner of his guarantee, and the refinancing was part of a plan of which one of the principal purposes was avoiding the disguised-sale rules, then the reduction in the amounts allocable to the partner would be considered an amount transferred to the partner. In the alternative, if the debt allocable to the partner were reduced because the debt was paid off via cash generated in the ordinary course of business of the partnership, the reduction would not be considered an amount transferred to the partner under the anticipated-reduction rule.

The proposed regulations add a new rule under the anticipated-reduction rule that relates to proposed amendments to the Sec. 752 regulations. Under this new provision, if a partner's net value is decreased within two years of the transfer of the property and results in a decrease in the amount of liabilities allocable to that partner under Sec. 752, then the reduction will be presumed to be anticipated, unless the facts and circumstances clearly establish that the decrease in net value was not anticipated. A reduction in liabilities under these circumstances must be disclosed in accordance with Regs. Sec. 1.707-8.

Tiered Partnerships and Mergers

The current disguised-sale regulations contain limited rules with respect to tiered partnerships. The proposed regulations vastly expand on these rules. An in-depth analysis of these rules is beyond the scope of this item. However, their intent is to adopt a purely aggregate theory with respect to tiered entities. Under this analysis, a transfer by a partner of an interest in a partnership to another partnership would be examined as if the partner had transferred his proportionate share of the transferred partnership's assets and liabilities. The proposed regulations also make clear that the tiered-partnership rules apply to multiple-tiered partnerships.

In the case of the merger of two partnerships, where the partners transfer their interest in a partnership to another partnership in exchange for an interest in the latter resulting in the dissolution of one of the partnerships, the proposed regulations under Sec. 707 adopt the netting rules under Regs. Sec. 1.752-1(f) to determine the amount transferred to a partner with respect to liabilities assumed, or property taken subject to the liabilities, by the surviving partnership.

Proposed Amendments to Sec. 752 Regs.: Partner's Share of Liabilities

Recourse liabilities: Under existing Regs. Sec. 1.752-2, a partner's share of a recourse partnership liability equals the portion of the liability for which the partner or a related person bears the ultimate economic risk of loss. To determine this amount, the regulations assume that the partnership's property is worthless (the "A-Bomb" theory) and then looks to whom the responsibility falls to pay the liability. To the extent a partner or a related person bears this responsibility, the liability is allocated to that partner. The regulations in general ignore whether the partner to whom the liability is allocated has the economic wherewithal to in fact meet the obligation and assumes that all partners and related persons will actually satisfy their obligation.

There are two general exceptions to this rule: The first is the disregarded-entity rule, which provides that when the responsibility for payment of a liability falls to a disregarded entity, the amount of the liability so allocated with respect to this disregarded entity is limited to the net value of the entity. The second is the satisfaction presumption, which would again limit the amount of the liability allocable to a partner to net value where the facts and circumstances indicate that a plan exists to circumvent or avoid the obligation.

Treasury believes that partnerships and partners are entering into guarantees and other arrangements that would not be commercially reasonable, such that liabilities of the partnership would be allocable to the partner even though exposure to economic risk of loss is nonexistent or minimal. Treasury is concerned that in many situations the A-Bomb theory is not the appropriate test, since both the lender and the borrowing partnership expect that the liability will be repaid in the normal course of partnership operations or via the liquidation of partnership property.

Accordingly, the proposed regulations provide a rule that an obligation of a partner or related person with respect to a partnership liability will not be recognized unless certain factors are present. These factors are intended to establish that the partner or related person's obligation with respect to a liability is commercially reasonable. Under the proposed regulations, the following factors must be met before a portion of a debt can be allocated and treated as recourse with respect to a partner:

  • The partner or related person must maintain a commercially reasonable net worth during the term of the payment obligation or be subject to commercially reasonable restrictions on asset transfers.
  • The partner or related person must provide commercially reasonable documentation regarding its financial condition;
  • The partner or related person must receive arm's-length consideration for assuming the payment obligation (guarantee fee);
  • The partner's or related person's obligation must not end prior to the term of the partnership's liability;
  • The primary obligor (or other obligors) must not be required to hold money or other liquid assets in an amount that exceeds the reasonable needs of the obligor; and
  • In the case of a guarantee or similar arrangement, the partner or related person must be liable up to the full amount of the payment obligation to the extent that any amount of the partnership's liability is not otherwise satisfied. (In the case of an indemnity, reimbursement, or similar arrangement, the partner or related person must be liable up to the full amount of its obligation to the extent the indemnitee makes a payment to satisfy the liability.)

These rules would prevent situations such as "bottom-dollar guarantees" and similar arrangements and would adopt anti-abuse rules where "financial intermediaries" or other persons are used to create senior and subdebt tantamount to a bottom-dollar guarantee situation. The final two requirements are put forth to avoid situations such as several guarantees where a partner's exposure is limited by guaranteeing only a vertical slice of an obligation.

Example (12) of Prop. Regs. Sec. 1.752-2(f) clarifies this situation further. Under this example, four partners enter into a guarantee of a partnership debt, and each partner is responsible for paying 25% of any amount unrecovered by the lender. Assume the original debt is $1,000, and the lender is paid only $750 of the debt by the partnership. Individually, under the terms of the guarantee, the guarantor partner is obligated to pay only his share of the unrecovered amount, or $62.50 (25% of $250). In this case, since the partner's obligation is limited, the regulations would require the guarantee to be ignored for purposes of determining the amount of debt to be allocated to the partner. Essentially, the regulations would force a guarantee of a partnership debt obligation by multiple parties to be made on a joint-and-several basis, where in the previous example the lender could recover the unpaid portion in total from any of the guarantors.

This rule obviously eliminates the A-Bomb theory put forth in the existing regulations. As previously stated, under the A-Bomb theory, the assumption is that at the time of the guarantee, the partnership's assets are deemed worthless and the liability allocable to the partner is his share of the unpaid obligation. So, in this example, the lender is deemed to recover $0 from the partnership, and the guaranteeing partners are on the hook for their share, or $250. Thus, the partner is allocated $250 whether the guarantee is several or joint and several.

The proposed regulations also expand the net-value limitation to all partners and related persons other than those partners or related persons that are either individuals or estates of individuals. This rule was previously applied only to disregarded entities. The rules encompassing other entities would also apply to a grantor trust. In the preamble to the regulations, Treasury indicated that it will continue to study the net-value limitation and expressed a concern that excluding individuals from the rules may disadvantage nonindividual partners where a partnership comprises both types of partners.

Finally, under existing Regs. Sec. 1.752-2(b)(1), a partner's payment obligation is reduced by any amount for which he is entitled to reimbursement from a partner or related person. The proposed regulations would expand this rule to include any reimbursement from any person. Thus, an indemnity from a third party unrelated to the partnership would require a reduction in the amount of the obligation allocable to the partner.

Nonrecourse liabilities: The proposed regulations address the method in which excess nonrecourse liabilities (as defined in Regs. Sec. 1.752-3(a)(3)) are allocated to partners. The current regulations provide three methods: the profits-interest method, the significant-item method, and the alternative method. The proposed regulations would substitute these methods with a single permissible method. Under Prop. Regs. Sec. 1.752-3(a)(3), excess nonrecourse liabilities would be allocated among the partners based on their liquidation-value percentage. A partner's liquidation-value percentage is the ratio of the amount a partner would receive if the partnership sold its assets for FMV, paid off its liabilities, and distributed the remainder to the partners in accordance with the partnership agreement, divided by the total amount to be distributed to the partners in the hypothetical liquidation. Under the proposed regulations, the liquidation percentage would be calculated at formation and recalculated each time an event described under Regs. Sec. 1.704-1(b)(2)(iv)(f) occurs (property revaluation or book-up events).

Effective Dates

Generally, the proposed regulations under Sec. 707 will apply to transactions entered into on or after the date the regulations are published as final in the Federal Register . Prop. Regs. Secs. 1.752-2 and 1.752-3 will apply to liabilities incurred or assumed by a partnership and to payment obligations imposed or undertaken with respect to a partnership liability on or after the date the final regulations are published in the Federal Register .

The proposed regulations also provide transition relief for any partner whose share of partnership liabilities exceeds its adjusted basis on the date the regulations become final. Under the transition rule, the partner may rely on the existing regulations for a period of seven years, to the extent of the excess. The transition relief would be reduced for certain subsequent events that would otherwise reduce the amount by which the liabilities exceed the partner's basis in the partnership.

Real Estate Industry Concerns

Although the proposed regulations may provide some level of clarity, if finalized in their current form, they would add another level of complexity and would further restrict the flexibility of structuring transactions, particularly those involving leveraged partnerships. Several groups have already provided comments to the IRS regarding the detrimental effect these regulations would have on the way business deals are normally structured within the real estate industry.

Of particular concern is how the proposed regulations will affect the formation of real estate investment trusts (REITs) via an umbrella partnership real estate investment trust (UPREIT) structure. In the past, the IRS has generally blessed these structures as non-tax-avoidance structures. However, the proposed changes to Regs. Secs. 1.752-2 and 1.752-3 would severely limit the ability to defer the recognition of gain in the UPREIT structure and render it a useless means by which to raise capital and diversify investment in an industry still struggling to recover from the Great Recession.

In its comment letter, a group of national real estate organizations that included several prominent industry trade groups stated lengthy concerns regarding the negative impact the proposed regulations would have on the real estate industry (available at regulations. gov , No. IRS-2014-0007-0002). Of particular concern is the potential retroactive application the regulations would have on arrangements currently in place. The comment letter compared the effective dates of the regulations with those of the passive loss rules implemented under the Tax Reform Act of 1986, P.L. 99-514.


Anthony Bakale is with Cohen & Co. Ltd., Cleveland.

For additional information about these items, contact Mr. Bakale at 216-774-1147 or

Unless otherwise noted, contributors are members of or associated with Cohen & Co. Ltd.

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