ADVANCED PARTNERSHIP DEBT ALLOCATIONS Howard E. Abrams April/May 2014

BASIC RULES  Recourse debt is allocated in accordance with risk of loss, usually based on a hypothetical zero-value sale and liquidation.  Nonrecourse debt is allocated according to three tiers:  T1: The minimum gain tier.  T2: The minimum §704(c) gain tier.  T3: The residual (profits interests) tier.  Note: There is no third category of partnership debt. If a debt is partially recourse and partially nonrecourse, it is treated as two separate debts.

DYNAMIC RECOURSE DEBT: EX. 1  P and Q each contribute $30 to the PQ general partnership in exchange for 50% of profits and losses. The partnership borrows $40 on a fully recourse basis. How is the debt allocated between P and Q? PQ CAOBCAOB

DYNAMIC RECOURSE DEBT: EX. 1  Putting the debt into the outside bases as the partners share risk of loss, the books become: PQ CAOBCAOB

DYNAMIC RECOURSE DEBT: EX. 1  Suppose the partnership now distributes $40 of cash to partner P. The books of the venture become: PQ CAOBCAOB

DYNAMIC RECOURSE DEBT: EX. 1  But we need to consider the possibility that the distribution works a reallocation of the debt even though the amount of the debt has not changed and loss sharing ratios have not changed. PQ CAOBCAOB $ 0---

DYNAMIC RECOURSE DEBT: EX 1  The debt has thus shifted entirely to P, and so the books actually become: PQ CAOBCAOB Even though the distribution was made only to P, each partner’s outside basis declines by $20 from $50 to $30.

DYNAMIC RECOURSE DEBT: EX. 2  X contributes $10 while Y and Z each contribute $100 to the XYZ general partnership. Each partner has a one-third share of profits and losses. The partnership borrows $60 on a fully recourse basis. A zero- value sale and liquidation yields a negative capital account only for X, and so X is allocated all of the debt. The books become: XYZ CAOBCAOBCAOB

DYNAMIC RECOURSE DEBT: EX. 2  Suppose the partnership now distributes $70 to X. That reduces the partnership’s cash down to $200, and a zero-value sale and liquidation will leave only X with a capital account deficit. Accordingly, all of the debt remains with X and the books of the venture become: XYZ CAOBCAOBCAOB

DYNAMIC RECOURSE DEBT: EX. 2  Now suppose that the partnership distributes $80 to Y. That reduces the partnership’s cash down to $120. Prior to any reallocation of the debt, the books become: XYZ CAOBCAOBCAOB

DYNAMIC RECOURSE DEBT: EX. 2  Now let’s do a zero-value sale and liquidation. The partnership has $120 of cash, and assuming that falls in value to zero, each partner is allocated $40 of the loss. After the zero-value sale, the books of the venture become: XYZ CAOBCAOBCAOB

DYNAMIC RECOURSE DEBT: EX. 2  Because the debt is now allocated 5/6’s to X and 1/6 to Y, one-sixth of the debt (that is, $10 of the debt) is shifted to Y. But because X’s outside basis is already zero, that means the cash distribution to Y triggers gain recognition to X. XYZ CAOBCAOBCAOB (10)

NONRECOURSE DEBT: DEPRECIATION AND BOOK-UPS  X contributes $1,000,000 and Y contributes Blackacre to XY-LLC, and Blackacre is worth $1,000,000 with an adjusted basis of $200,000 at the time of contribution. The partnership borrows $2,000,000 and uses its cash of $3,000,000 to improve Blackacre. These improvements can be recovered straight-line over 25 years, and the debt encumbers Blackacre as well as the improvements. On these figures, the property has an initial book value of $4,000,000, an adjusted basis of $3,200,000, and a depreciable basis of $3,000,000. There is depreciation of $120,000 per year for 25 years.

NONRECOURSE DEBT: DEPRECIATION AND BOOK-UPS YearBook ValueAdj. BasisDep. BasisDebt 04,000,0003,200,0003,000,0002,000, ,080,0001,280,0001,080,0002,000, ,960,0001,160,000960,0002,000, ,600,000800,000600,0002,000,000 YearTier 1Tier 2Tier 3Total 0002,000, ,0001,280,0002,000, ,000800,0001,160,0002,000, ,000800,000 2,000,000

RELATED PARTY DEBT RULES  New related party debt rules were proposed on December 16, 1013, as Prop. Reg. § (b). The following discussion is based on these proposed regulations.

RELATED PARTY DEBT RULES Loan from Z to XY P YXZ XY

RELATED PARTY DEBT RULES Loan from Z to XY P YXZ XY Guarantee

RELATED PARTY DEBT RULES Loan from Z to XY P YXZ XY Partial Guarantee

PARTIAL SALE  If a partner owning a single partnership interest sells a portion of that interest, gain is computed by comparing the amount realized on the sale with a proportionate part of the outside basis.  The same rule applies if the partner owns multiple interests in the venture and sells only a part of his ownership interest without regard to how the interests were acquired (no tracing of basis).  A partner has a single, unified outside basis.  A partner has a single, unified capital account.  After the sale, the capital account of the selling partner that is attributable to the interest transferred carries over to the transferee.

PARTIAL SALE EXAMPLE  T joins the P partnership by contributing cash of $5,000 in exchange for a general partnership interest. Sometime later, T acquires a limited partnership interest for $7,000. Thereafter, when T’s combined outside basis in the two interests is $12,000, T sells one of the interests for its fair market value of $5,000. At the time of the sale, the two interests are worth $15,000.  T recognizes a gain of $1,000 on the sale (amount realized of $5,000 less $4,000 allocable portion of adjusted basis).  Note that it does not matter which interest is sold or whether that particular interest has increased or decreased in value (no tracing).

PARTIAL SALE: REV. RUL  If a partner sells a portion of his partnership interest and the selling partner has been allocated a share of the partnership’s liabilities, those liabilities not shifting as a result of the sale are removed from the selling partner’s outside basis immediately prior to the sale for the purpose of computing gain or loss on the sale.  Suppose X and Y each own half of the XY partnership, and XY owns Blackacre with inside basis of $400, value of $500, and subject to a debt of $380. Each partner has an outside basis of $200 including each partner’s $190 share of the debt.  Suppose Y sells one-half of her partnership interest to Z for its fair market value of $30.

REV. RUL EXAMPLE  If half of Y’s share of the debt shifts to Z, then gain on the sale equals amount realized of $125 (cash received plus debt shifted) less allocable portion of adjusted basis of $100, for a gain of $25.  If no part of the debt shifts, then gain on the sale equals amount realized of $30 (cash received) less allocable portion of outside basis with debt removed (that is, one-half of ($200 - $190)) of $5, for a gain of $25.

SALE AFTER DEFT-FINANCED DISTRIBUTION  X and Y own 60% and 40% of the profits and losses of XY-LLC. The partnership owns a single, nondepreciable asset with inside basis and book value of $0 but current value of $2,000. Each partner has a capital account and outside basis of $0. The partnership has an election under section 754 in effect and the partnership agreement provides that partnership assets will be booked to fair market value whenever allowable.  The partnership borrows $500 on a recourse basis, allocable 60% to X and 40% to Y. The loan proceeds are then distributed in those percentages.  Y sells half of her interest to Z for its value of $300.

SALE AFTER DEFT-FINANCED DISTRIBUTION XYZ CAOBCAOBCAOB

SALE AFTER DEBT-FINANCED DISTRIBUTION: SALE OF PROPERTY XYZ COBCAOBCAOB