Cost Segregation and Residential Rental Property

Purchasers of residential real estate, like purchasers of commercial property, can gain faster tax benefits by using a popular asset depreciation technique called cost segregation. 

Using cost segregation, buyers are permitted to view a real estate acquisition as consisting not only of land and buildings but also of tangible personal property and land improvements. The tax savings come from accelerated depreciation deductions applied to the segregated classifications otherwise lost in the general application of whole costs assigned to buildings and land only.  

A taxpayer can use cost segregation when constructing residential real property, buying an existing one, or, in certain circumstances, years after disposing of one or a portion of one so long as the year of disposition is still open under the statute of limitations (see revenue procedure 2004-11).

The trick (and its law...this is not just a device to evade) is to segregate the costs into components, tangible property (whenever possible) and land improvements, most of which allow for shorter periods of depreciation, and hence provide for faster tax benefits associated with the related allowances. 

See more about costs segregation at: 

http://www.journalofaccountancy.com/issues/2004/aug/costsegregationapplied.html#sthash.jetg7AW0.dpuf

Understanding the Tax Consequences of Guarantees of Partnership and LLC Debt - Part 2 of a 2 part series

One of the more confusing aspects of ownership in either a partnership or limited liability company (LLC) is understanding the effect that partnership or LLC debt has on an individual partner’s or member’s tax basis in that entity.  Knowing how debt affects one’s basis in an entity is important in determining how much a partner or member can deduct in losses that are otherwise passed through to him or her from that entity.

More importantly, it may be the deciding factor in determining the correct structure for the creation of an operating company.  

The Basic Basis Rules 01

Perhaps this is a good time to review the general rules of determining a partner’s or member’s tax basis in his or her interest.  A member/partner’s tax basis, in the context of the ability to deduct losses starts with the following:

Basis in the member’s (partner’s) interest is increased by –

- The amount of cash or the value of other assets he or she contributes to the entity,

- Any profits or gains allocated to that member/partner, and

- Any increase in the member/partner’s share of entity debt.

Basis in the member’s (partner’s) interest is decreased by –

- The amount of cash or value of other assets withdrawn from the entity by the member/partner,

- Any losses allocated to that member/partner, and

- Any decrease in the member/partner’s share of entity debt.

A further limitation on the ability to deduct losses can be found within the at-risk rules: where a member or partner can only deduct losses to the extent he or she is considered to be economically at-risk.  So, in order to be able to deduct a $100 loss, one otherwise allocated to him in accordance with the entity’s operating agreement, a member or partner has to actually be in a position to lose $100 in real money.  This is generally referred to as the amount the partner or member is “at-risk”.  And as such the partner/member must determine his or her at-risk basis as well.

Why is this important? Well, if you look back to the items (above) that increase or decrease basis, you will note that an increase or decrease in a member or partner’s share of LLC or partnership debt can either increase or decrease that member or partner’s basis in the LLC or partnership. However, it is important to understand that there are two different types of debt that will have very different effects on a member/partner’s regular tax basis or “at-risk basis”; recourse and nonrecourse debt.

Recourse debt is debt that is backed by collateral from the borrower, in this case the partnership or LLC. It is debt generally where the partners are personally liable.  While nonrecourse debt is the opposite. It is debt where no partner or member has personal liability for its repayment.  So, a partner’s at-risk basis will include cash or property they have contributed to the partnership, plus their share of partnership debt for which they (1) are personally liable for repayment, (2) or where they have pledged property held outside of the partnership as security, or have directly loaned to the partnership.   So recourse debt does not qualify or increase basis.

There is one additional type of debt that can increase a partner’s at-risk basis, and that is qualified nonrecourse debt.  Qualified nonrecourse debt is financing that is (1) borrowed from a qualified lender (2) for the purpose of holding real property (3) for which no person is personally liable for repayment and (4) which is not convertible debt. So, here we have a case of debt that no one is responsible for repaying that still increases all the partners’ at-risk basis amounts.

Now, with a fundamental understanding of at-risk basis and recourse vs. nonrecourse debt, let’s look at the differences between partnership and LLC treatment. In the partnership world, there are two types of partners; general partners and limited partners. General partners generally receive no protection from personal liability for the debts of the partnership and are fully liable for those debts, while limited partners generally are protected from personal liability for any partnership debts, except for any debts they have personally guaranteed.

While virtually every partnership has at least one general partner who is fully liable for partnership debts, that is not the case with LLCs. In most instances, LLC members are treated as limited partners, having no personal liability for the LLC debts. How does that affect an LLC member’s at-risk amount or basis?

The IRS’s Clarification in AM 2014-003

The IRS released an Associate Chief Counsel Memorandum (AM 2014-003) that provides guidance to the issue of the at-risk rules, partnerships and LLCs.  It does this by answering four specific questions. Additionally, the memorandum’s guidance applies both to LLCs classified as partnerships and single member LLCs (SMLLCs) treated as disregarded entities for federal tax purposes.

The first of the four questions outlined in the memorandum starts out fairly simply as it relates to the topic of debt and the at-risk rules with each subsequent question adding an additional layer of complexity. It is through this process that the guidance is developed as follows:

Question 1 asks what tax consequences surface under the at-risk rules of Code Sec. 465 to an LLC member who guarantees debt of that LLC. The response to this question explains in fairly significant but simple detail that, assuming the guarantee is legitimate, the LLC member will be able to increase his or her at-risk basis by the amount of the debt that has been personally guaranteed.

Question 2 then asks what tax consequences apply to an LLC member who guarantees debt of that LLC when the guaranteed debt is “qualified nonrecourse financing”.  As I outlined earlier, qualified nonrecourse debt is debt financing that is (1) borrowed from a qualified lender (2) for the purpose of holding real property (3) for which no person is personally liable for repayment and (4) which is not convertible debt. Again, we have a case of debt that no one is responsible for repaying that still increases all the partners’ at-risk basis amounts. 

The response to question 2 explains that once a member has guaranteed qualified nonrecourse debt, his (and only his) at-risk basis will increase, as in question 1.  But the commentary goes on to explain that, since a member is now guaranteeing the repayment of this debt, the debt no longer meets the definition of qualified nonrecourse financing, which in turn affects the other non-guaranteeing members. The significance of this treatment is addressed in the next question.

Question 3 builds upon question 2 by outlining the tax consequences to the other non-guaranteeing members where one member has guaranteed qualified nonrecourse financing.  As explained in the response to question 2, since the debt no longer meets the definition of qualified nonrecourse debt financing, the non-guarantor members may no longer include their share of that debt in the computation of their respective at-risk amounts.  It also adds that if a reduction in their at-risk amounts occurs, causing their respective cumulative at-risk amounts (basis) to fall below zero, then the partners or members must recognize income to that extent.

Question 4 deviates from the above scenarios by repeating question 2, above, but limiting it to the member of an SMLLC. In this case, there are no other LLC members who are affected, and the SMLLC member sees no change in his at-risk basis. Why? As qualified nonrecourse debt, the member already had at-risk basis for that debt. By guaranteeing that debt, he still has at-risk basis, so the amount of his at-risk basis didn’t change. Unfortunately, in this case, his personal liability with regard to that debt went from zero to the amount he guaranteed.

With this memorandum, the IRS has provided some relatively uncomplicated guidance to a very complex issue (even though it probably didn’t sound particularly uncomplicated).

Guarantor of LLC Debt: Additional Basis for Losses?

Guarantor of LLC Debt: Additional Basis for Losses?  Part 1 of a 2 part series

It is quite common for LLC members to guarantee operating loans that have been advanced to/or secured by their LLC. While a member’s guaranty usually means that the amount of the guaranteed debt is included in the member’s basis in his or her LLC membership interest, does that actually mean that the member can take loss deductions against that debt? Many tax professionals may be surprised to learn that the answer is generally “No.”

Suppose that members A, B, and C form an LLC called Rock Steady LLC. Each member puts in $10,000 in cash. The LLC elects to obtain a $100,000 loan from a local bank for working capital which only member B personally guarantees.  In the first year, the LLC incurs a net loss of $45,000, which is to be allocated in accordance with the entity's operating agreement equally among the members. What portion of this loss is deductible by the members, if any?

Under the normal partnership tax basis rules found in I.R.C. Section 752, the losses sustained and allocated to the members is limited to their individual basis in their interest in the LLC.  Additionally, B’s guaranty of the loan allows for the inclusion of the entire amount of the loan in B's basis, whereas the other members may not include any portion of the loan in their basis computations. Hence, members A and C are denied a basis increase and as such are limited as to the amount of loss each of them can deduct. In this case A and C cannot deduct more than $10,00 each. 

Because the $100,000 of debt is included in B's basis, B's basis is increased. Does this mean that B's loss is fully deductible? The answer not only depends on the member's basis limitation, but also depends upon the at-risk rules under I.R.C. 465. The at-risk rules are the second of three rules that an LLC member must satisfy in order to fully deduct allocated losses. The first rule is the basis limitation. The third set of rules, which is not covered herein, is the passive loss rules under Code Section 469. 

The at-risk rules, in essence, limit the amount of any loss deduction by an LLC member to the “amount the LLC member is at risk.” While one might think that because the guaranteed loan is included in B’s basis under the partnership basis rules, the member must also be considered at risk for that amount, but that is often not the case. That is because the rules under I.R.C. 465 say that if a taxpayer guarantees repayment of an amount borrowed by another person (ie. a primary obligor, which in this case, is the LLC) for use in an activity, the guarantee cannot increase his or her amount at risk. The taxpayer's amount at risk is not increased until such time as the taxpayer actually makes good on the guarantee.

The reason for this result is that under the law of most states, as between the guarantor and the primary debtor, the guarantor is considered only secondarily liable for the debt. If the guarantor has to make good the guarantee when the primary debtor defaults, then by law in most states a guarantor usually has a right to recover in a civil action from the primary debtor any amount that the guarantor paid.  The right, then, to recover from the LLC prevents the guarantor from being considered “at risk” for the amount of the debt.  

This question often arises in conjunction with an analysis of an LLC’s Schedule K-1s, the schedule which shows a member’s share of LLC debt as being either “recourse” or “non-recourse.” If a debt is listed as “recourse” on a member’s K-1, does that mean the member is at-risk for that amount? Under the laws in most states, a loan made to an LLC is generally “nonrecourse” as to the members, unless the members or a member guaranteed it. A member may include guaranteed debt in the member’s basis, but that does not mean that the member is at risk for that amount (1). However, recently the IRS and the courts have ruled that a member will be deemed to be at risk in the circumstance where there is a sole guarantor. 

(1) the entity's debt may be listed as “recourse” on a schedule K-1 but a member cannot tell whether or not the member is at risk for that amount merely by looking at the K-1.