Making sense of nonrecourse deductions in partnership taxation

It is well established that partnerships and limited liability companies (LLCs) taxed as partnerships have flexibility when it comes to allocating income. Partnerships may allocate items of income, gain, loss, deduction, or credit in the manner outlined in the partnership agreement.¹ If the allocation in the partnership agreement does not have substantial economic effect, the allocation will be determined in accordance with the partner’s interest in the partnership.² The general premise of substantial economic effect is that tax allocations follow book allocations. That is, allocations of taxable income, gain, loss, deduction, or credit are made in a way that follows the true economic arrangement of the partnership and partners.

Specific provisions of the Internal Revenue Code and Treasury regulations limit the flexibility described above for certain scenarios and/or tax items. Of relevance to this article are those provisions surrounding nonrecourse deductions in the context of partnerships and LLCs taxed as partnerships.³ More specifically, allocations of losses, deductions, or expenditures that are attributable to partnership nonrecourse liabilities (known as nonrecourse deductions) cannot have economic effect because the lender alone bears the economic risk of loss associated with the expense.⁴ Thus, under Sec. 704(b), nonrecourse deductions must be allocated using the partner’s interest in the partnership.⁵ Allocations of nonrecourse deductions will be deemed made in accordance with the partner’s interest in the partnership so long as the corresponding test under the regulations is met (also known as the “safe harbor”).⁶

Character of liability

Before discussing the mechanics of allocating nonrecourse deductions and meeting the safe harbor, it is important to understand the different types of partnership and LLC liabilities.

A nonrecourse liability is one where no partner or related person bears the economic risk of loss associated with it.⁷ An example is a loan secured by collateral where the lender has no right to seek judgment against any partner’s personal assets in the event of default.

Conversely, a recourse liability is one where any partner or related person bears the economic risk of loss on that liability.⁸ Whether a partner bears the economic risk of loss is determined under Regs. Sec. 1. 752-2. While there are many exceptions and nuances to these regulations, most frequently a partner is considered to bear the risk of economic loss related to a liability if:

1. Upon a constructive liquidation (defined under Regs. Secs. 1.752-2(b) (1)(i)–(v)) of the partnership, the partner would be obligated to make payment because the liability became due and payable, known as a “payment obligation”;⁹ or
2. The partner is the lender.¹⁰ In this case, the entire liability is allocated to that partner.

Once it is determined that a liability is indeed a recourse liability and more than one partner/member may be liable beyond their capital commitment, it is allocated under the regulations,¹¹ using the aforementioned constructive liquidation. The constructive liquidation is a hypothetical scenario in which the partnership or LLC’s recourse debts become due and all assets, including cash, are deemed worthless and sold for no consideration. Losses from the deemed sale are then allocated to partners in accordance with the partnership agreement. The extent to which partners or members must restore a remaining negative capital account reflects their economic risk of loss and thus their share of recourse debt.

As a practical note, typically under state law, general partners are responsible for debts beyond their partnership investment. Limited partners and limited members, however, are typically not. There are exceptions to this if, for example, the lender explicitly agrees to give a nonrecourse loan to a general partner or, conversely, a limited partner personally guarantees a loan.

If a limited partner or limited member personally guarantees a nonrecourse liability, the guarantee must satisfy an anti-abuse test under the regulations.¹² The guarantee must not be made solely to achieve economic risk of loss and atrisk basis for that partner (i.e., not be transitory). Two of the factors in the anti-abuse test that can indicate abuse are: (1) a partner/member is not subject to commercially reasonable contractual restrictions that protect the likelihood of payment, and (2) a partner/member is not required to provide commercially reasonable documentation regarding their financial condition.

Example 1: AB general partnership is formed by general partners A and B, each having contributed $100 cash for 50% interests in the partnership. A and B split all items of income, gain, loss, And deduction equally. The partnership applies for and receives $800 of financing from a bank and purchases land for $1,000. Three years later, with the principal balance of the liability still being $800, the land has depreciated in value and is now worth $500. The land is foreclosed on, and the bank takes possession.

Because both partners are general partners and the bank did not explicitly outline that the loan was nonrecourse, the debt is recourse to the partnership and the partners. The bank can pursue partners A and B personally outside the partnership for the remaining $300 deficiency ($800 principal balance of debt minus the $500 land repossessed). Compare this to a scenario where AB is an LLC, and both A and B are limited members. Importantly, the bank did not explicitly outline that the loan was recourse, nor did A or B guarantee the repayment of the debt. Should the property be foreclosed on, the bank would not be able to pursue limited members A and B personally for the remaining $300 deficiency, as the debt is nonrecourse. Thus, the bank as the lender bears the economic risk of loss, not the members.

A partner’s share of nonrecourse liabilities under the regulations¹³ is equal to the sum of:

1. The partner’s share of partnership minimum gain;
2. Sec. 704(c) gain allocable to the partner; and
3. The partner’s share of excess nonrecourse liabilities, determined in accordance with profit ratios of the partnership.

The remainder of this article discusses nonrecourse deduction allocations and minimum gain chargebacks and their relation to point 1 above.¹⁴ (Minimum gain chargebacks in the context of tiered partnerships are not covered in this article.)

The nonrecourse deduction allocation safe harbor

As previously mentioned, allocations of nonrecourse deductions cannot have substantial economic effect because the lender alone bears the economic risk of loss associated with the deduction. Thus, these nonrecourse deductions must be allocated in accordance with the partner’s interest in the partnership, which is generally a facts-and-circumstances-based test and is typically undesirable for the partnership, as the outcome is uncertain if litigated. The regulations contain a provision,¹⁵ sometimes referred to as a safe harbor, under which the allocation of nonrecourse deductions will be respected and considered to be in accordance with the partner’s interest in the partnership. There are four requirements for the safe harbor, all of which must be met. They are:

1. Substantial-economic-effect rules are met throughout the full term of the partnership;¹⁶
2. Allocations of nonrecourse deductions are made in a manner that is reasonably consistent with other allocations of the partnership that have substantial economic effect;¹⁷
3. The partnership agreement contains a provision that complies with the minimum gain chargeback regulations;¹⁸ and
4. All other material allocations under the partnership agreement are respected under Regs. Sec. 1.704- 1(b). This is similar to the first requirement.¹⁹

A detailed discussion of substantial economic effect is outside the scope of this article, but the topic is written about extensively in published articles and trainings.²⁰

Regarding the safe harbor’s second requirement, that nonrecourse deductions be allocated in a manner that is reasonably consistent with other allocations of the partnership that have substantial economic effect, consider the following:

Example 2: G and L form GL limited partnership. The partnership agreement provides that G, as a general partner, is allocated 10% of all income, gain, loss, and deduction until the partnership earns a net profit, in which case G will then receive 50%. Conversely, L, as a limited partner, will receive 90% of all items until the partnership earns a net profit, in which case L will then receive 50%. Assume the preceding allocations all have substantial economic effect.

If the allocations of nonrecourse deductions are not explicitly outlined in the partnership agreement and follow the rest of the partnership items, then by default they will meet the reasonably consistent requirement. However, should nonrecourse deductions be specifically allocated in the partnership agreement, so long as in the example above they fall in the range of between 10% and 50% for G and between 90% and 50% for L, it is safe to assume they will meet the reasonably consistent requirement, as the allocations fall in the range of others with substantial economic effect.²¹ If nonrecourse deductions in the example above were to be allocated 99% and 1%, for example, they would not meet the reasonably consistent requirement.²²

Moving to the third requirement of the safe harbor, which is that the partnership agreement contain a provision complying with the minimum gain chargeback regulations, these chargebacks are a result of net decreases in partnership minimum gain.²³ Accordingly, to fully grasp the minimum gain chargeback aspect of the safe harbor, it is critical to first understand what a partnership minimum gain is.

Partnership minimum gain

Minimum gain chargebacks are a result of net decreases in partnership minimum gain.²⁴ The amount of nonrecourse deductions for a tax year is determined by increases in partnership minimum gain, reduced by nonrecourse distributions.²⁵ Partnership minimum gain is determined under the regulations by computing for each partnership nonrecourse liability the gain the partnership would realize if it disposed of the property subject to the liability for no consideration other than satisfaction of the liability and then aggregating the separately computed gains.²⁶ It is best to understand the preceding sentence with an example.

Example 3: AB LLC is owned equally by limited members A and B, both contributing $100 cash. The only asset AB owns is a building it purchased with a fair market value (FMV) of $1,000, which is encumbered with an $800 nonrecourse loan. The building is depreciated for tax and book purposes over 10 years using the straight-line method. At the end of year 3, the tax and book basis of the building is $700 ($1,000 purchase price minus $300 of depreciation), and the principal balance of the loan is still $800.

In this scenario, AB has taken $300 of depreciation on the building; however, its original net equity value was only $200 ($1,000 building minus $800 loan). In effect, AB has depreciated the building by an amount greater than its equity value; part of the $800 nonrecourse loan proceeds is being used to generate tax depreciation deductions. The excess of the $100 depreciation deduction over the $200 equity value is known as partnership minimum gain.

Partnership minimum gain is generally increased by basis reductions of the underlying asset below its outstanding nonrecourse liability or by additional nonrecourse borrowing that exceeds the underlying asset’s tax basis. Furthermore, since the amount of nonrecourse deductions for a tax year is determined by increases in partnership minimum gain,²⁷ AB has nonrecourse deductions for the tax year of $100 as well.

Partnership minimum gain is allocated to a partner under the regulations²⁸ in an amount generally equal to:

1. The sum of nonrecourse deductions allocated to the partner, plus distributions made to the partner with proceeds of a nonrecourse liability allocable to an increase in partnership minimum gain,²⁹ minus
2. The sum of the partner’s share of net decreases in partnership minimum gain, plus their share of decreases resulting from revaluations of partnership property subject to a nonrecourse liability.³⁰

For any tax year, a partnership’s net increase or decrease in partnership minimum gain is measured by the difference between the immediately preceding tax year’s partnership minimum gain on the last day of the year, compared with the partnership minimum gain on the last day of the current tax year.³¹

To illustrate why the term “minimum gain”³² is used and its mechanics, consider the following:

Example 4: Assume the same facts as in Example 3; however, at the start of year 4, when the tax and book basis was $700, the bank foreclosed on the property in full satisfaction of the $800 loan.

Under Regs. Sec. 1.1001-2, the amount realized in a sale or disposition of property generally includes the amount of nonrecourse liabilities relieved. Considering this in the example above, at the end of year 3, AB has incurred a “minimum” $100 gain on the foreclosure of the building ($800 nonrecourse debt discharged minus $700 basis).³³ Recall reading earlier that minimum gain chargebacks are a result of net decreases in partnership minimum gain. In this example, the partnership minimum gain of $100 was reduced to $0 due to the foreclosure and relief of liability. Thus, AB partnership must comply with the minimum gain chargeback rules.³⁴

The minimum gain chargeback rules are in place to ensure that those partners that benefited from nonrecourse deductions or nonrecourse distributions later recognize minimum gain, in the same proportion, on the disposition of the underlying asset secured by the nonrecourse debt that generated the nonrecourse debt deductions or distributions.

Example 5: Assume the same facts as in Example 4; however, the AB LLC agreement stated that all nonrecourse deductions were to be allocated 30% to A and 70% to B. Additionally, assume there was a minimum gain chargeback provision in the LLC agreement and the nonrecourse deduction allocations are reasonably consistent with others having substantial economic effect.

Before the foreclosure at the start of year 4, recall that the $100 of minimum gain is a result of basis reductions of the building below the principal balance of the liability. The $100 is also the amount of nonrecourse deductions, as nonrecourse deductions are determined by increases in partnership minimum gain for the year.³⁵ Accordingly, $30 of the nonrecourse deductions are allocated to A and $70 to B. At the start of year 4, when the property is foreclosed on, a minimum gain chargeback is triggered as a result of a net decrease in the $100 partnership minimum gain.

Thus, the minimum gain chargeback requires items of income and gain to be allocated to A and B equal to their share of net decrease in partnership minimum gain. In this case, $30 of minimum gain is to be allocated to A and $70 to B, which is equal to the amount of net partnership minimum gain decrease each partner incurred for the year because of the foreclosure.

Partnership minimum gain does not increase solely by way of nonrecourse deductions. Nonrecourse distributions³⁶ are another item that can increase partnership minimum gain for the year. Nonrecourse distributions are distributions of nonrecourse loan cash proceeds secured by an underlying asset, to the extent that the nonrecourse loan principal balance exceeds the underlying asset’s tax basis.

Consider the following:

Example 6: AB LLC is owned equally by limited members A and B. AB LLC holds an unencumbered building; its FMV is $1,000 and its tax basis is $400 due to depreciation deductions. AB LLC takes out a $600 cash nonrecourse loan from a bank, secured by the building, and immediately distributes the proceeds to A and B, $300 respectively.

Before the nonrecourse financing was received from the bank, there was no partnership minimum gain. Afterward, however, the principal balance of the nonrecourse note was more than the underlying asset’s tax basis it secured. Accordingly, there is minimum gain of $200 in the form of a nonrecourse distribution because AB LLC distributed the cash nonrecourse loan proceeds. Each partner’s share of the nonrecourse distribution is $100, or the amount by which the $300 distributed to them exceeded their $200 share of the tax basis in the building. If AB LLC were to dispose of the property for $0 and full satisfaction of the $600 loan, $200 of minimum gain would be allocated to A and B in an amount equal to their shares of the nonrecourse distribution ($100 each).

Exceptions to partnership minimum gain

The regulations explicitly outline scenarios that do not cause a minimum gain chargeback. These include:

Conversions and refinancings: Should a net decrease in partnership minimum gain be caused by a conversion of nonrecourse financing to recourse, a minimum gain chargeback would not be triggered. This is logical, as a recourse liability is one where a partner is liable beyond their capital commitment in a partnership.³⁷

Capital contributions: Should a partner contribute capital to the partnership that is used to pay down the principal balance of the nonrecourse liability or to increase the basis of the property subject to the nonrecourse liability, the decrease in partnership minimum gain would not cause a minimum gain chargeback.³⁸

Waiver: Should a partnership have a net decrease in partnership minimum gain for a tax year where a minimum gain chargeback would cause a “distortion in the economic arrangement among the partners,” the partnership may request a waiver by the IRS.³⁹

Revaluations: Should a partnership asset have a book value that differs from its tax basis, partnership minimum gain would be determined by reference to the asset’s book value.⁴⁰ This scenario largely occurs because of a partnership revaluation,⁴¹ also known as a partnership “book-up.” While partnership revaluations are not in the scope of this article, in general, a book-up increases the asset’s Sec. 704(b) book value to its FMV for purposes of creating a layer of Sec. 704(c) built-in gain.

If the partnership had an asset encumbered by a nonrecourse liability that exceeded its tax basis and the partnership booked up its assets to FMV, this could decrease partnership minimum gain inherent in that asset by means of the new book value being greater than its tax basis. The decrease attributable to the partnership revaluation does not result in a minimum gain chargeback,⁴² and moving forward, the partnership is to use the asset’s book value to determine net increases or decreases in partnership minimum gain.

Allocations follow benefits

The regulations under Regs. Sec. 1. 704-2 are vast. The overarching theme is that the partners that enjoyed the benefits of a nonrecourse deduction or distribution are subject to minimum gain in an equal amount.

Footnotes

¹Sec. 704(a).

²Sec. 704(b).

³Regs. Sec. 1.704-2.

⁴Regs. Sec. 1.704-2(b)(1).

⁵Id.

⁶Regs. Sec. 1.704-2(e).

⁷Regs. Sec. 1.752-1(a)(2).

⁸Regs. Sec. 1.752-1(a)(1).

⁹Regs. Sec. 1.752-2(b).

¹⁰Regs. Sec. 1.752-2(c).

¹¹Regs. Sec. 1.752-2(b)(1).

¹²Regs. Sec. 1.752-2(j).

¹³Regs. Sec. 1.752-3(a).

¹⁴Under Sec. 465(b)(6)(B), a liability may be considered qualified nonrecourse. Generally, qualified nonrecourse liabilities are those where the underlying asset securing the financing is real property. These liabilities increase the partners’ at-risk basis for the purposes of Sec. 465. Qualified nonrecourse liabilities are allocated in the same manner as other nonrecourse liabilities.

¹⁵Regs. Sec. 1.704-2(e).

¹⁶Regs. Sec. 1.704-2(e)(1).

¹⁷Regs. Sec. 1.704-2(e)(2).

¹⁸Regs. Sec. 1.704-2(e)(3). This is widely regarded as the heart of Regs. Sec. 1.704-2 and is discussed in detail in this article.

¹⁹Regs. Sec. 1.704-2(e)(4).

²⁰See, e.g., Seaton, “Target Allocations,” 42 The Tax Adviser 230 (April 2011).

²¹See Regs. Sec. 1.704-2(m), Example1(ii) for a detailed example of a reasonably consistent nonrecourse allocation.

²²See Regs. Sec. 1.704-2(m), Example 1(iii), for an example of a nonrecourse allocation that is not reasonably consistent.

²³Regs. Sec. 1.704-2(f)(1).

²⁴Id.

²⁵Regs. Sec. 1.704-2(c).

²⁶Regs. Sec. 1.704-2(d)(1).

²⁷Regs. Sec. 1.704-2(c).

²⁸Regs. Sec. 1.704-2(g).

²⁹These distributions are often referred to as “nonrecourse distributions” and are discussed later in the article.

³⁰Revaluations in the context of minimum gain are discussed later.

³¹Regs. Sec. 1.704-2(d)(1).

³²This is also referred to as “Tufts gain” due to a Supreme Court case in which the Court held that the full balance of a nonrecourse liability discharged in a property sale or other disposition must be included in the amount realized, even if its balance is greater than the tax basis of the property it secures (Tufts, 461 U.S. 300 (1983)).

³³Also recall Regs. Sec. 1.704-2(d)(1) and the hypothetical scenario of discharging property for no consideration other than satisfaction of the liability.

³⁴Regs. Sec. 1.704-2(f).

³⁵Regs. Sec. 1.704-2(j) provides an ordering rule for nonrecourse deductions. Nonrecourse deductions first consist of cost recovery from the property secured by the nonrecourse debt. If there is not enough cost recovery to cover the increase in partnership minimum gain, then a pro rata portion of the partnership’s other deductions and losses are used. If there is still an excess of partnership minimum gain increase, it is carried over into the subsequent year.

³⁶Regs. Sec. 1.704-2(h).

³⁷Regs. Sec. 1.704-2(f)(2).

³⁸Regs. Sec. 1.704-2(f)(3).

³⁹Regs. Sec. 1.704-2(f)(4).

⁴⁰Regs. Sec. 1.704-2(d)(3).

⁴¹Regs. Sec. 1.704-1(b)(2)(iv)(f).

⁴²Regs. Sec. 1.704-2(d)(4).

Contributor 

Eric Homsany, CPA, is a senior tax associate with Arena Investors LP in New York City. For more information about this article, contact thetaxadviser@aicpa.org.

AICPA & CIMA RESOURCES

Article 

Burton, “Current Developments in Partners and Partnerships,” 55-2 The Tax Adviser 28 (February 2024) 

CPE self-study 

Advanced Taxation LLCs & Partnerships — Tax Staff Essentials 

Reviewing Partnership Tax Returns: What Are You Missing? 

Tax Fundamentals of LLCs and Partnerships — Tax Staff Essentials

Tax Section materials (for members) 

2023 Partnership/LLC Income Tax Return Checklist — Form 1065 (Mini) 

2023 Partnership/LLC Income Tax Return Checklist — Form 1065 (Short) 

2023 Partnership/LLC Income Tax Return Checklist — Form 1065 (Long)

For more information or to make a purchase, visit aicpa-cima.com/cpe-learning or call 888-777-7077.