On January 30^th, the IRS issued proposed regulations on bottom-dollar guarantees, igniting a firestorm of negative reaction from real estate investors.¹  If these rules are adopted, many UPREIT partners will incur substantial tax on the paper gain associated with a negative capital account balance. While transition relief would delay the impact for some taxpayers, the proposed bottom-dollar rules are written to become retroactive seven years after being adopted. UPREITs and their partners need to prepare themselves.

Property Acquisitions by UPREITs

An UPREIT (umbrella partnership) is a limited partnership formed by a REIT (real estate investment trust) to acquire and operate rental real estate. The REIT controls the UPREIT partnership as its general partner.  The UPREIT structure has become a standard acquisition vehicle for real estate, because it provides the owners of target properties with diversification and access to liquidity, without requiring their immediate recognition of taxable gain.²  An owner disposing of real estate to an UPREIT does so by contributing the property to the partnership in exchange for UPREIT units, which are typically exchangeable, after a waiting period, for shares of a publicly traded REIT.  The taxable gain on the contributed properties is effectively deferred until the UPREIT units are converted into publicly traded REIT shares.³

If there is a mortgage on a contributed property, the UPREIT generally takes over the liability.  In order for the contributing partner’s tax gain to be deferred, the UPREIT partnership must provide at the outset—and must continue to provide—the contributing partner with a sufficient allocation of partnership-level indebtedness to offset the partner’s negative capital account.⁴

The liability amount needing to be allocated will be a function of the tax history of the contributed property.  For example, if the property has generated non-cash tax losses, or if the owner has refinanced a mortgage to take cash out, that history may produce a negative balance in the incoming partner’s capital account at the time the property is contributed to the UPREIT.  If so, that partner will need a large enough allocation of UPREIT partnership liabilities to offset the negative capital account balance.  A shortfall in allocated liabilities would entail the recognition of taxable gain for this investor, whether it exists at the outset or it arises after the investor has held the UPREIT units for some time.

Allocation of Liabilities by UPREITs

Complex regulations⁵ tell the partnership how to allocate its liabilities among its partners for such tax purposes. If the UPREIT takes over a nonrecourse mortgage on the contributed property, the nonrecourse liability allocation rules may initially provide the contributing partner with a large enough debt allocation to offset all or most of his negative capital account balance.⁶  But over time the paydown of principal, as well as other factors, may leave the contributing partner without a large enough liability allocation to offset his negative capital account.  For that reason, UPREIT partnerships frequently agree to provide a contributing limited partner with an allocation of recourse indebtedness in a specified amount, and for a specified period of time, negotiated when the deal is struck for the UPREIT’s acquisition of a property.

For tax purposes, recourse indebtedness is allocated among partners based on how the economic burden of the liability is shared. The current regulations look to which of the partners would pay the liability, and in what amounts, if (i) all partnership assets including cash became worthless and (ii) the partnership were then liquidated.⁷  This approach, which tests a partner’s exposure to liability in the worst case theoretically imaginable, has been called the “Constructive Liquidation Test” (or less prosaically, the “atom-bomb theory”).  As The Real Estate Roundtable points out:

The Constructive Liquidation Test is intended to allow a partnership to allocate its liabilities without making a difficult or impossible assessment as to the likelihood that a partner’s obligation will in fact become due and payable or whether a partner will in fact have the net worth to satisfy its obligation.  It provides an administrable regime and prevents the government from being “whipsawed” as a result of differing assessments [of these uncertain prospects].⁸

In reliance on this 22-year-old rule of administrative convenience, the “bottom-dollar guarantee”⁹ has become a familiar feature of mortgage financing for properties in an UPREIT portfolio.  Under a bottom-dollar guarantee, a partner undertakes to guarantee a real estate mortgage, but the guarantor’s liability will arise only to the extent that the fair market value of the mortgaged property has dropped below the amount of the guarantee.  For example, with a $25 million mortgage loan, a bottom-dollar guarantee might cover only the “bottom” $5 million of the loan.  This means that if the lender, having exhausted all other sources of payment, has been able to recover only $1 million, then the guarantor will have to pay $4 million; and if the collateral has become worthless and the lender has been unable to recover any portion of the loan from other sources, the bottom-dollar guarantor’s liability is capped at $5 million.

It is standard practice for an UPREIT to commit itself in an acquisition agreement to maintain a negotiated amount of liability allocation to an incoming partner, and then to fulfill that covenant by relying on the effectiveness of a bottom-dollar guarantee to make the guaranteed indebtedness a “recourse” obligation of the guarantor for tax purposes.  In its January 30th proposed regulations, the IRS took aim at this industry practice.  The proposal’s preamble plainly states that the new rule for recourse liabilities “would…prevent…so-called ‘bottom-dollar’ guarantees from being recognized for purposes of section 752.”¹⁰   In fact, the January 30th proposal not only includes an anti-abuse provision “to address the use of intermediaries, tiered partnerships, or similar arrangements to avoid the bottom-dollar guarantee rules,”¹¹  but it also invites comments identifying anything else that could be targeted as a circumvention of these rules.  Clearly the IRS means to get rid of bottom-dollar guarantees, root and branch.

Effective Date and Transition Relief

In general, these restrictive regulations would apply to liabilities incurred or assumed by a partnership after the regulations are finalized and made effective.¹²   Limited transition relief would be given to certain partners (“Transition Partners”) who would be placed in a taxable gain position if recourse liabilities allocated to them under the current regime were shifted to other partners under the new bottom-dollar rules.¹³   This relief appears designed to allow a partnership some scope to refinance its guaranteed debt, or to offset with a new borrowing a debt reduction resulting from required amortization or other pay-down of indebtedness; it is not unusual in such instances for an UPREIT to make a replacement allocation of partnership liabilities available to an affected partner.

A Transition Partner cannot obtain this relief without the participation of the partnership involved; the partnership must adopt this method of liability allocation in preparing its tax returns.¹⁴ Moreover, if the Transition Partner is itself a partnership (as UPREIT partners often are), then the transition relief is lost “[i]f the direct or indirect ownership of that Transition Partner changes by 50 percent or more.”¹⁵  For an investor holding UPREIT units through a partnership that makes the benefit of transition relief contingent on stability in the ownership structure of the holding partnership, a matter over which the investor may well have no control.

The duration of the proposed transition relief would be limited to seven years, starting when these proposed regulations are finalized and first take effect.  At the end of the seven-year period, all transitional relief would expire for UPREIT partners who were otherwise able to rely on bottom-dollar guarantees for an allocation of partnership liabilities under the transition rules.¹⁶ Without some alternative source of tax basis to cover their negative capital accounts, these investors would then be taxed on phantom (non-cash) gains. 

UPREIT partners with negative capital accounts should monitor the progress of the proposed IRS rules ignoring bottom-dollar guarantees, and should track the amount of tax which would be owed if the proposals are adopted.  In the meantime, we may see a chilling effect on future property acquisitions by UPREITs.

_{¹ REG – 119305-11 (January 30, 2014).  As explained in a related GT Alert, the IRS attack on bottom-dollar guarantees is part of a package of proposed regulations that would substantially reduce the flexibility allowed to partnerships in allocating their liabilities--both recourse and nonrecourse--among partners for tax purposes.  In addition to triggering the recognition of taxable gain by some partners with negative capital accounts, these proposed regulations would reduce an UPREIT partner’s ability to receive tax-free distributions, and to deduct Schedule K-1 tax losses.} 

_{² Unless steps are taken, as described below, gain will be recognized on the contribution of the property to the UPREIT if the amount of liabilities encumbering the property exceeds the tax basis of the property in the hands of the transferor.} 

_{³ Current regulations expressly confirm that the IRS considers this favorable tax treatment acceptable in principle.  See Treas. Regs. §1.701-2(d), Example 4.} 

_{⁴ In this context the determination of a partner’s negative capital account balance is made on a tax accounting basis.} 

_{⁵ Treas. Regs. §§1.752-2 through 1.752-6.} 

_{⁶ See Treas. Regs. §1.752-3(a)(2) (allocation of second-tier nonrecourse liabilities).  The January 30, 2014 proposed regulations would not change this provision.} 

_{⁷ See Treas. Regs. §1.752-2(b)(1), T.D. 8380 (1991).  This provision is modified by a relatively weak anti-abuse rule; a much stronger one would be introduced by the proposed regulations.}

_{⁸ March 13, 2013 letter of Jeffrey D. DeBoer to Mark Mazur, Treasury Assistant Secretary for Tax Policy, and Charles Wilkins, IRS Chief Counsel.} 

_{⁹ This type of guarantee is sometimes called a “bottom-slice guarantee” or simply a “bottom guarantee.”} 

_{¹⁰ REG – 119305-11, “Explanation of Provisions,” section 8 A.  The proscription of bottom-dollar guarantees, somewhat obliquely worded, is found in Prop. Reg. §1.752-2(b)(3)(ii)(F), and illustrated in Examples 10 and 11, Prop. Reg. §1.752-2(f).   Section 752 of the Internal Revenue Code is the statute governing the allocation of partnership liabilities.}

 _{¹¹ REG – 119305-11, “Explanation of Provisions,” section 8 A; see Prop. Reg. §1.752-2(j)(4).}

_{¹² Prop. Reg. §1.752-2(l)(2).  The regulations as proposed would also apply to a pre-effective-date partnership liability, if an additional payment obligation is imposed on (or undertaken by) a partner after the effective date.} 

_{¹³ “The proposed regulations … provide transitional relief for any partner whose allocable share of partnership liabilities under § 1.752-2 exceeds its adjusted basis in its partnership interest on the date the proposed regulations are finalized.”  REG – 119305-11, “Proposed Applicability Dates”.} 

_{¹⁴ Prop. Reg. §1.752-2(l)(2)(i).} 

_{¹⁵ Prop. Reg. §1.752-2(l)(2)(ii). It appears that this provision, as written, would count a transfer at death towards the 50 percent threshold.} 

 _{¹⁶ Prop. Reg. §1.752-2(l)(2)(i).  Upon the sale of any property by the UPREIT partnership during the seven-year period, its Transition Partners would suffer a partial loss of transition relief, in an amount determined under a prescribed formula.}