[Federal Register Volume 63, Number 149 (Tuesday, August 4, 1998)]
[Rules and Regulations]
[Pages 41420-41423]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-20801]
=======================================================================
-----------------------------------------------------------------------
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 8777]
RIN 1545-AV17
Qualified Nonrecourse Financing Under Section 465(b)(6)
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
-----------------------------------------------------------------------
SUMMARY: This document contains final regulations on certain issues
regarding qualified nonrecourse financing under section 465(b)(6).
These final regulations affect individuals and C corporations for which
the stock ownership requirement of section 542(a)(2) is satisfied.
These regulations provide guidance on certain issues relating to
section 465(b)(6).
DATES: Effective date: These regulations are effective August 4, 1998.
Applicability dates: See Effective Dates under Supplementary
Information of the preamble.
FOR FURTHER INFORMATION CONTACT: Jeff Erickson at (202) 622-3070 (not a
toll-free number).
SUPPLEMENTARY INFORMATION:
Background
This document amends 26 CFR part 1 to provide rules regarding
qualified nonrecourse financing under section 465(b)(6). Section 465
limits a taxpayer's loss deduction for an activity to the taxpayer's
amount at risk in the activity at the close of the taxable year. A
taxpayer's amount at risk generally includes the amount of any cash and
the adjusted tax basis of any property contributed by the taxpayer to
the activity plus any amounts borrowed for use in the activity to the
extent the taxpayer is personally liable for repayment. For the
activity of holding real property, section 465(b)(6) provides that a
taxpayer may include as an amount at risk the taxpayer's share of any
qualified nonrecourse financing that is secured by real property used
in the activity of holding real property, even though the taxpayer is
not personally liable for repayment of the financing.
On August 13, 1997, the IRS published in the Federal Register (62
FR 43295) a notice of proposed rulemaking regarding section 465(b)(6).
A number of comments were received on the proposed regulations. The
public hearing scheduled for December 10, 1997, was canceled because no
one requested to speak. After considering the written comments, the
proposed regulations are adopted as revised by this Treasury decision.
Explanation of Provisions
I. Secured by Real Property
A. Proposed Rule
Section 465(b)(6)(A) provides that qualified nonrecourse financing
must be secured by real property used in the activity of holding real
property. The proposed regulations provided that a financing can be a
qualified nonrecourse financing if, in addition to the real property
used in the activity of holding real property, the financing is secured
by other property that is incidental to the activity of holding real
property (incidental property).
B. Discussion of Comments
A commentator recommended that the final regulations clarify the
term incidental property. Another commentator asked that the IRS and
Treasury define incidental property as any property with a value of not
more than 15 percent of the value of the real property held by the
borrowing partnership. A third commentator explained that real estate
partnerships often hold assets in addition to real property and
incidental property. This commentator was concerned that only
financings held by partnerships that own only real estate assets could
satisfy the proposed regulations. Under the final regulations, if the
total gross fair market value of property that is neither real property
used in the activity of holding real property nor incidental property
is less than 10 percent of the total gross fair market value of all the
property securing the financing, such other property is ignored in
determining whether the financing satisfies the secured-by-real-
property requirement.
Another commentator asked for a look-through rule for partnerships
that own an interest in another partnership to determine the character
of the assets securing a qualified nonrecourse financing. The final
regulations adopt this suggestion by requiring a borrower (whether or
not a partnership) to determine the character of its assets by treating
itself as owning directly its proportional share of the assets in any
partnership in which it owns (directly or indirectly through a chain of
partnerships) an equity interest. If a borrower pledges a partnership
interest as security for a financing, the partnership assets
attributable to the borrower's proportional share of the partnership's
assets will be treated as security for the financing.
[[Page 41421]]
Commentators also asked under what circumstances qualified
nonrecourse financing will be treated as secured by real property.
Because this issue is closely-related to the determination of whether
the personal liability of a partnership will be disregarded, those
issues are addressed together and are discussed in II. Personal
Liability of this preamble.
A commentator suggested that the final regulations adopt a rule to
allocate a single debt obligation among multiple brother-sister
partnerships when the obligation is secured by the assets of more than
one partnership. The IRS and Treasury believe this issue is beyond the
scope of these regulations.
II. Personal Liability
A. Proposed Rule
Section 465(b)(6)(B)(iii) provides that, except to the extent
provided in regulations, no person may be personally liable for
repayment of a qualified nonrecourse financing. The proposed
regulations provided that the personal liability of a partnership
(including a limited liability company that is treated as a
partnership) is disregarded in determining whether a financing is a
qualified nonrecourse financing if the entity's only assets are real
property used in the activity of holding real property or both real
property and other property that is incidental to the activity of
holding real property, and no other person is liable for the financing.
B. Discussion of Comments
Commentators focused on how the proposed regulations apply to
tiered partnership structures--when a partnership (the upper-tier
partnership) owns a partnership interest in another partnership (the
lower-tier partnership). These commentators questioned whether the
personal liability of an upper-tier partnership that holds, directly or
indirectly, only real property or incidental property should disqualify
a financing under section 465(b)(6). As mentioned in I. Secured by Real
Property of this preamble, commentators also requested guidance as to
the situations in which a nonrecourse financing will be treated as
secured by real property.
In order to address these comments, the final regulations adopt a
three-part test. Under the final regulations, the personal liability of
any partnership will be disregarded and, provided certain other
requirements are satisfied, the financing will be treated as qualified
nonrecourse financing secured by real property if (i) the only persons
personally liable to repay the financing are partnerships; (ii) each
partnership with personal liability holds only property that is
permitted as security for qualified nonrecourse financing (applying a
look-through rule for lower-tier partnerships); and (iii) in exercising
its remedies to collect on the financing in a default or default-like
situation, the lender may proceed only against property that is
permitted as security for qualified nonrecourse financing and that is
held by the partnership or partnerships (applying a look-through rule
for lower-tier partnerships). Similar principles apply in determining
the treatment of financing incurred by an entity that is disregarded
for federal tax purposes under Sec. 301.7701-3 of the Procedure and
Administration Regulations. The final regulations contain three
examples illustrating the application of these rules to tiered
partnerships and one example addressing a situation that involves a
disregarded entity.
III. Other Issues
A commentator asked that the final regulations clarify whether an
entity is disregarded for purposes of section 465(b)(6) if that entity
is disregarded as separate from its owner under Sec. 301.7701-3. An
entity that is disregarded as an entity separate from its owner under
Sec. 301.7701-3 is disregarded under section 465(b)(6). Certain rules
that apply to financings involving disregarded entities are discussed
above.
Commentators also raised several other issues, including the
treatment of publicly traded financing, that are beyond the scope of
these regulations.
IV. Effective Dates
The final regulations are effective for any financing incurred on
or after August 4, 1998. In response to comments, however, the final
regulations include a provision allowing taxpayers to apply the
regulations retroactively for financing incurred before August 4, 1998.
If a taxpayer chooses to apply these regulations retroactively to
financing incurred before August 4, 1998, the IRS will require the
taxpayer to reduce the amounts at risk as a result of the application
of the regulations to taxable years ending before August 4, 1998, only
to the extent the application increases the losses allowed for such
years.
Special Analyses
It has been determined that this Treasury decision is not a
significant regulatory action as defined in EO 12866. Therefore, a
regulatory assessment is not required. It also has been determined that
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)
does not apply to these regulations, and because the regulation does
not impose a collection of information on small entities, the
Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply.
Therefore, a Regulatory Flexibility Analysis is not required. Pursuant
to section 7805(f), the notice of proposed rulemaking preceding these
regulations was submitted to the Chief Counsel for Advocacy of the
Small Business Administration for comment on its impact on small
business.
Drafting Information: The principal author of these regulations is
Jeff Erickson, Office of the Assistant Chief Counsel (Passthroughs and
Special Industries), IRS. However, other personnel from the offices of
the IRS and Treasury Department participated in their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR Part 1 is amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 is amended by adding
an entry in numerical order to read as follows:
Authority: 26 U.S.C. 7805 * * *
Sec. 1.465-27 also issued under 26 U.S.C. 465(b)(6)(B)(iii).* *
*
Par. 2. Section 1.465-27 is added to read as follows:
Sec. 1.465-27 Qualified nonrecourse financing.
(a) In general. Notwithstanding any provision of section 465(b) or
the regulations under section 465(b), for an activity of holding real
property, a taxpayer is considered at risk for the taxpayer's share of
any qualified nonrecourse financing which is secured by real property
used in such activity.
(b) Qualified nonrecourse financing secured by real property--(1)
In general. For purposes of section 465(b)(6) and this section, the
term qualified nonrecourse financing means any financing--
(i) Which is borrowed by the taxpayer with respect to the activity
of holding real property;
(ii) Which is borrowed by the taxpayer from a qualified person or
represents a loan from any federal, state,
[[Page 41422]]
or local government or instrumentality thereof, or is guaranteed by any
federal, state, or local government;
(iii) For which no person is personally liable for repayment,
taking into account paragraphs (b)(3), (4), and (5) of this section;
and
(iv) Which is not convertible debt.
(2) Security for qualified nonrecourse financing--(i) Types of
property. For a taxpayer to be considered at risk under section
465(b)(6), qualified nonrecourse financing must be secured only by real
property used in the activity of holding real property. For this
purpose, however, property that is incidental to the activity of
holding real property will be disregarded. In addition, for this
purpose, property that is neither real property used in the activity of
holding real property nor incidental property will be disregarded if
the aggregate gross fair market value of such property is less than 10
percent of the aggregate gross fair market value of all the property
securing the financing.
(ii) Look-through rule for partnerships. For purposes of paragraph
(b)(2)(i) of this section, a borrower shall be treated as owning
directly its proportional share of the assets in a partnership in which
the borrower owns (directly or indirectly through a chain of
partnerships) an equity interest.
(3) Personal liability; partial liability. If one or more persons
are personally liable for repayment of a portion of a financing, the
portion of the financing for which no person is personally liable may
qualify as qualified nonrecourse financing.
(4) Partnership liability. For purposes of section 465(b)(6) and
this paragraph (b), the personal liability of any partnership for
repayment of a financing is disregarded and, provided the requirements
contained in paragraphs (b)(1)(i), (ii), and (iv) of this section are
satisfied, the financing will be treated as qualified nonrecourse
financing secured by real property if--
(i) The only persons personally liable to repay the financing are
partnerships;
(ii) Each partnership with personal liability holds only property
described in paragraph (b)(2)(i) of this section (applying the
principles of paragraph (b)(2)(ii) of this section in determining the
property held by each partnership); and
(iii) In exercising its remedies to collect on the financing in a
default or default-like situation, the lender may proceed only against
property that is described in paragraph (b)(2)(i) of this section and
that is held by the partnership or partnerships (applying the
principles of paragraph (b)(2)(ii) of this section in determining the
property held by the partnership or partnerships).
(5) Disregarded entities. Principles similar to those described in
paragraph (b)(4) of this section shall apply in determining whether a
financing of an entity that is disregarded for federal tax purposes
under Sec. 301.7701-3 of this chapter is treated as qualified
nonrecourse financing secured by real property.
(6) Examples. The following examples illustrate the rules of this
section:
Example 1. Personal liability of a partnership; incidental
property. (i) X is a limited liability company that is classified as
a partnership for federal tax purposes. X engages only in the
activity of holding real property. In addition to real property used
in the activity of holding real property, X owns office equipment, a
truck, and maintenance equipment that it uses to support the
activity of holding real property. X borrows $500 to use in the
activity. X is personally liable on the financing, but no member of
X and no other person is liable for repayment of the financing under
local law. The lender may proceed against all of X's assets if X
defaults on the financing.
(ii) Under paragraph (b)(2)(i) of this section, the personal
property is disregarded as incidental property used in the activity
of holding real property. Under paragraph (b)(4) of this section,
the personal liability of X for repayment of the financing is
disregarded and, provided the requirements contained in paragraphs
(b)(1)(i), (ii), and (iv) of this section are satisfied, the
financing will be treated as qualified nonrecourse financing secured
by real property.
Example 2. Bifurcation of a financing. The facts are the same as
in Example 1, except that A, a member of X, is personally liable for
repayment of $100 of the financing. If the requirements contained in
paragraphs (b)(1)(i), (ii), and (iv) of this section are satisfied,
then under paragraph (b)(3) of this section, the portion of the
financing for which A is not personally liable for repayment ($400)
will be treated as qualified nonrecourse financing secured by real
property.
Example 3. Personal liability; tiered partnerships. (i) UTP1 and
UTP2, both limited liability companies classified as partnerships,
are the only general partners in Y, a limited partnership. Y borrows
$500 with respect to the activity of holding real property. The
financing is a general obligation of Y. UTP1 and UTP2, therefore,
are personally liable to repay the financing. Under section 752,
UTP1's share of the financing is $300, and UTP2's share is $200. No
person other than Y, UTP1, and UTP2 is personally liable to repay
the financing. Y, UTP1, and UTP2 each hold only real property.
(ii) Under paragraph (b)(4) of this section, the personal
liability of Y, UTP1, and UTP2 to repay the financing is disregarded
and, provided the requirements of paragraphs (b)(1)(i), (ii), and
(iv) of this section are satisfied, UTP1's $300 share of the
financing and UTP2's $200 share of the financing will be treated as
qualified nonrecourse financing secured by real property.
Example 4. Personal liability; tiered partnerships. The facts
are the same as in Example 3, except that Y's general partners are
UTP1 and B, an individual. Because B, an individual, is also
personally liable to repay the $500 financing, the entire financing
fails to satisfy the requirement in paragraph (b)(1)(iii) of this
section. Accordingly, UTP1's $300 share of the financing will not be
treated as qualified nonrecourse financing secured by real property.
Example 5. Personal liability; tiered partnerships. The facts
are the same as in Example 3, except that Y is a limited liability
company and UTP1 and UTP2 are not personally liable for the debt.
However, UTP1 and UTP2 each pledge property as security for the loan
that is other than real property used in the activity of holding
real property and other than property that is incidental to the
activity of holding real property. The fair market value of the
property pledged by UTP1 and UTP2 is greater than 10 percent of the
sum of the aggregate gross fair market value of the property held by
Y and the aggregate gross fair market value of the property pledged
by UTP1 and UTP2. Accordingly, the financing fails to satisfy the
requirement in paragraph (b)(1)(iii) of this section by virtue of
its failure to satisfy paragraph (b)(4)(iii) of this section.
Therefore, the financing is not qualified nonrecourse financing
secured by real property.
Example 6. Personal liability; Disregarded entity. (i) X is a
single member limited liability company that is disregarded as an
entity separate from its owner for federal tax purposes under
Sec. 301.7701-3 of this chapter. X owns certain real property and
property that is incidental to the activity of holding the real
property. X does not own any other property. For federal tax
purposes, A, the sole member of X, is considered to own all of the
property held by X and is engaged in the activity of holding real
property through X. X borrows $500 and uses the proceeds to purchase
additional real property that is used in the activity of holding
real property. X is personally liable to repay the financing, but A
is not personally liable for repayment of the financing under local
law. The lender may proceed against all of X's assets if X defaults
on the financing.
(ii) X is disregarded so that the assets and liabilities of X
are treated as the assets and liabilities of A. However, A is not
personally liable for the $500 liability. Provided that the
requirements contained in paragraphs (b)(1)(i), (ii), and (iv) of
this section are satisfied, the financing will be treated as
qualified nonrecourse financing secured by real property with
respect to A.
(c) Effective date. This section is effective for any financing
incurred on or after August 4, 1998. Taxpayers, however, may apply this
section retroactively for financing incurred before August 4, 1998.
[[Page 41423]]
Approved: July 16, 1998.
Michael P. Dolan,
Deputy Commissioner of Internal Revenue.
Donald C. Lubick,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 98-20801 Filed 8-3-98; 8:45 am]
BILLING CODE 4830-01-P
