Is Nonrecourse Debt Included in Basis?

Key Takeaways:

Nonrecourse debt can provide basis for distributions, but generally does not provide at-risk basis.
A partner’s share of partnership nonrecourse debt adds to their basis in the partnership interest.
Qualified nonrecourse financing can generate at-risk basis for a partner.
Guarantees do not increase at-risk basis until the guaranteed debt is paid without reimbursement.
In conclusion, nonrecourse debt provides basis for distributions but not usually for at-risk rules.

Introduction

The treatment of nonrecourse debt can be a complex issue when determining basis in partnerships and S-corporations. Nonrecourse debt refers to loans secured by collateral, but with no personal liability if the borrower defaults. How this type of debt impacts basis depends on the specific situation.

This article will provide a comprehensive evaluation of how nonrecourse debt is treated for purposes of calculating basis. It will analyze the key considerations and exceptions regarding whether nonrecourse debt provides basis for distributions and for at-risk rules. The depth of information will help readers understand the nuances of these complex basis issues.

Gaining this understanding is critical for taxpayers and tax professionals when assessing basis, as incorrect basis can lead to inaccurate loss deductions or capital gain calculations. The analysis here aims to eliminate confusion on when nonrecourse debt increases basis versus when it does not. Readers will learn how factors like partnership interests, qualified nonrecourse financing, and guarantees impact basis treatment.

By the end, readers will have clarity on the role of nonrecourse debt in determining basis for distributions and at-risk limitations. With this knowledge, taxpayers can more accurately file their returns, enabling proper loss deductions and avoiding potential issues or penalties for incorrect basis reporting.

Does Nonrecourse Debt Provide Basis for Distributions?

A partner’s basis in their partnership interest determines how much they can deduct for partnership losses on their individual return. Basis also determines how much gain the partner must recognize when receiving distributions that exceed their basis. So whether nonrecourse debt increases basis is a key consideration.

In general, a partner’s share of nonrecourse debt taken on by the partnership does increase their outside basis in the partnership interest. This means it provides basis when determining how much gain the partner must recognize on distributions.

Why Nonrecourse Debt Increases Basis for Distributions

According to a 2018 Tax Court case (CCA 201810009), a partner’s share of nonrecourse debt incurred by the partnership increases the partner’s basis. The IRS Chief Counsel Advice memorandum states that a partner’s outside basis includes their share of partnership liabilities under IRC Section 752.

These rules apply even if the liability is nonrecourse debt where no partner bears personal responsibility. Therefore, nonrecourse debt typically increases a partner’s outside basis for purposes of limiting gain recognition on distributions.

However, an exception applies if the nonrecourse debt lacks economic substance or was taken on solely for tax avoidance. In those cases, the debt would not legitimately increase a partner’s basis.

Example of Nonrecourse Debt Increasing Basis

Here is an example of how nonrecourse debt increases a partner’s basis in a partnership:

John and Jane form an LLC partnership
The LLC borrows $100,000 from a bank in a nonrecourse loan
John has a 50% interest in the LLC, so $50,000 of the nonrecourse debt is allocated to him
This $50,000 share of nonrecourse debt increases John’s basis in his LLC interest
If John later receives a $60,000 cash distribution, he only recognizes gain on $10,000 since his basis was $50,000

Without the nonrecourse debt basis, John would have recognized the full $60,000 distribution as capital gain. So the nonrecourse debt allowed John to defer gain recognition.

Limits on Use of Nonrecourse Debt Basis

While nonrecourse debt provides basis for reducing gain on distributions, the IRS limits using this basis to generate artificial tax losses by reducing equity interests.

Treasury regulations prevent partners from cramming down nonrecourse debt to create losses exceeding their actual economic investment. This prevents exploiting nonrecourse debt basis when a partnership has no real assets.

Overall, nonrecourse debt legitimately increases basis for distributions. But anti-abuse rules limit manufacturing noneconomic losses through excessive debt compared to equity.

Does Nonrecourse Debt Provide At-Risk Basis?

While nonrecourse debt can increase basis for distributions, the same is not true for purposes of the at-risk rules under IRC Section 465. These rules limit loss deductions to the amount a taxpayer has economically “at risk” in the activity.

In general, nonrecourse debt does not provide at-risk basis that would allow deducting losses from the debt. However, exceptions apply in certain situations.

Why Nonrecourse Debt Typically Doesn’t Provide At-Risk Basis

Since the taxpayer has no personal liability with nonrecourse debt, they are not economically at risk for that amount. Therefore, nonrecourse debt generally does not provide at-risk basis that would allow deducting losses against that debt.

For example, say a taxpayer invested $10,000 cash in an activity and the activity took on $90,000 in nonrecourse debt. Their at-risk basis would only be the $10,000 cash invested. The $90,000 nonrecourse debt does not provide at-risk basis because there is no personal liability.

However, as explored next, certain exceptions can allow nonrecourse debt to provide at-risk basis when additional factors effectively put the taxpayer at risk.

Exceptions Where Nonrecourse Debt Provides At-Risk Basis

There are two main exceptions where nonrecourse debt can provide at-risk basis for deducting losses:

1. Qualified Nonrecourse Financing

Qualified nonrecourse financing is debt taken on by the activity that is secured by real property used in the activity. According to IRC Section 465(b)(6), this type of nonrecourse financing does add to the at-risk basis amount.

For example, say a rental real estate partnership obtains a nonrecourse mortgage loan secured by the property to finance improvements. Since the loan is secured by real property used in the activity, it is qualified nonrecourse financing. Thus, it provides at-risk basis that partners can use to deduct rental real estate losses against.

2. Guarantees

If the taxpayer personally guarantees repayment of a partnership’s or S corporation’s nonrecourse loan, this guarantee can provide at-risk basis. However, at-risk basis is only increased when the taxpayer actually pays part or all of the guaranteed debt without any right to reimbursement.

Merely guaranteeing the debt does not increase at-risk basis by itself. The partner must make actual payments on the guarantee for their at-risk amount to increase.

Overall, while nonrecourse debt typically does not create at-risk basis, these exceptions apply in certain situations like real estate activities or guaranteed loans.

FAQs About Nonrecourse Debt and Basis

Does a partner’s share of nonrecourse debt increase their stock basis in an S corporation?

Yes, similar to a partnership interest, an S corporation shareholder’s stock basis is increased by their allocable share of corporate nonrecourse debt under IRC Section 1366(d)(1)(B). This provides basis for reducing gain on distributions. However, this debt basis cannot create or increase losses passed through from the S corporation.

Does converting recourse debt to nonrecourse debt reduce basis?

Converting fully recourse debt into nonrecourse debt can reduce a partner’s share of liability, thereby decreasing their outside basis in the partnership interest under Treasury Regulation 1.1001-2. However, complex factors determine the exact basis impact, such as the debt balance, property value, and partner’s payment obligation.

Can a membership interest loan create basis even if structured as nonrecourse?

No, member loans in an LLC do not create basis because they are not considered partnership liabilities. Under Treasury Regulation 1.752-2, a partner loan is a liability of the partner, not a liability of the partnership. Therefore, a nonrecourse loan from member to LLC does not increase basis like a true partnership liability would.

Does the passive activity loss limit apply when debt basis creates a loss?

Yes, even if nonrecourse debt provides basis to generate a deductible loss, that loss is still subject to passive activity loss limits under IRC Section 469. So passive losses that rely on debt basis cannot offset nonpassive income like wages or portfolio income. The loss carries forward to offset future passive income.

Can basis from nonrecourse debt exceed the fair market value of property securing the debt?

Yes, there is no limit stating nonrecourse debt basis cannot exceed fair market value of property securing the debt. As long as the nonrecourse debt was not taken on solely for tax avoidance, it can provide full basis for distributions regardless of fair market value.

Conclusion

In summary, while complex in practice, the guidelines for nonrecourse debt basis can be summarized as:

Nonrecourse debt provides partner basis for reducing gain on distributions
But nonrecourse debt typically does not provide at-risk basis for generating deductible losses
Exceptions like qualified nonrecourse financing or guarantees can provide at-risk basis in some cases

Understanding these nuances is key for accurately determining basis when nonrecourse debt is involved. This prevents errors on returns and allows properly claiming losses and gains related to partnership or S-corporation activities. Incorrect basis can lead to unintended consequences like forfeited loss deductions or unnecessary capital gain.

With the comprehensive analysis provided throughout this article, readers now have a clearer picture of how nonrecourse debt impacts basis calculations. Partners and shareholders can feel more assured that they are treating nonrecourse debt correctly on their tax returns when computing loss deductions or gains. And with this knowledge, they can consult with tax professionals to ensure their specific situation is handled appropriately.

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