[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]


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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.

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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