The IRS recently released a generic legal advice memorandum (GLAM) reversing its position issued earlier this year with regard to the treatment of “nonrecourse carve-outs” or” bad boy” guarantees commonly provided in commercial real estate financing transactions.
What’s a “nonrecourse carve-out” or “bad boy” guarantee?
Real estate partnerships typically use a combination of partner equity and nonrecourse financing to acquire real property. The notes often contain certain language stating that certain acts (such as declaring bankruptcy) by the partnership will trigger a guarantee requirement by one or more of the partners. This is known as a “nonrecourse carve-out” or “bad boy” guarantee.
These triggering acts rarely occur because the acts are typically in the control of the guaranteeing partner who would have personal liability for the debt as a result of such acts.
The IRS Original Position
Earlier this year, the IRS issued a Chief Counsel Advice memorandum that said that a bad boy guarantee causes such notes to be treated as recourse debt. Instead of all partners receiving a share of the debt basis, this shifts all debt basis to the guaranteeing partner for purposes of applying the partnership basis allocation rules and the at-risk rules.
The New Revised Position
In the recently released GLAM, the IRS concludes that until one of the bad boy acts actually occurs and causes the guaranteeing partner to become personally liable for the debt, the guarantee will not cause the obligation to be characterized as recourse debt for purposes of applying the partnership basis allocation rules or the at-risk rules.
What are some of the bad boy acts/non-recourse carve-out events identified in the GLAM?
Can I rely on the GLAM?
The GLAM may not be used as precedent, but it confirms what most tax practitioners and real estate investors have believed all along, that typical bad boy guarantees will not ordinarily cause nonrecourse debts to be characterized as recourse debt for purposes of applying the partnership basis allocation rules and the at-risk rules.
How does this affect me?
If you have any real estate partnerships with loans containing bad boy guarantees (or if you’re not so sure), we would be happy to review the loan documents and discuss the tax implications to your partners. Please contact one of the following ATKG representatives: