Most real estate partnerships use a combination of equity and nonrecourse financing to fund projects.
Each partner bears the economic risk for equity or recourse liabilities, whereas he does not for nonrecourse liabilities.
Lenders only consider the assets of the partnership in nonrecourse financing to repay the loan. Even so, they frequently require the managing partner or a sponsor to provide a so-called “bad-boy” guarantee to secure the loan. Generally bad boy guarantees are considered qualified nonrecourse liabilities for income tax purposes and are not taken into consideration when determining if a debt is classified as recourse or nonrecourse.
To qualify as nonrecourse financing, a partner cannot be personally at risk for the economic loss. Additionally, the loan must be:
- Borrowed in connection with holding real property;
- Secured by real property used in the real estate activity, and
- Loaned or guaranteed by a federal, state or local government, or borrowed from a qualified person.
To claim a tax loss from a real estate partnership, a partner must have sufficient tax basis and at-risk investment in his partnership interest. Recourse liabilities are allocated only to the partners who are at risk, while nonrecourse and qualified nonrecourse financing is allocated among the partners according to how they share in the profits from the partnership. Recourse debt increases the partner’s tax basis in its partnership interest, which generally allows the partner to benefit from taking more tax deductions or, depending on the circumstance, receiving additional cash distributions without being subject to tax. Since no partner is at risk for nonrecourse debt, it can generally be allocated among all of the partners in accordance with their interests in the partnership as per the operating agreement. In certain situations, nonrecourse liabilities will be reclassified as recourse debt. If this occurs, only the partner that guaranteed the loan will benefit.
Typically, the bad boy guarantee is triggered if one of the following events take place:
- The borrower fails to obtain the lender’s consent before obtaining subordinate financing or transfer of the secured property; The borrower files a voluntary bankruptcy petition;
- The borrower files a voluntary bankruptcy petition; Any person in control of the borrower files an involuntary bankruptcy petition against the borrower;
- Any person in control of the borrower files an involuntary bankruptcy petition against the borrower; Any person in control of the borrower solicits other creditors of the borrower to file an involuntary bankruptcy petition against the borrower;
- Any person in control of the borrower solicits other creditors of the borrower to file an involuntary bankruptcy petition against the borrower; The borrower consents to or otherwise acquiesces or joins in an involuntary bankruptcy or insolvency proceeding;
- The borrower consents to or otherwise acquiesces or joins in an involuntary bankruptcy or insolvency proceeding; Any person in control of the borrower consents to the appointment of a receiver or custodian of assets; or
- Any person in control of the borrower consents to the appointment of a receiver or custodian of assets; or
- The borrower makes an assignment for the benefit of creditors or admits in writing or in any legal proceeding that it is insolvent or unable to pay its debts as they come due.
Because the party providing the guarantee is usually in control of the provisions mentioned above, bad boy guarantees are rarely triggered. Typically, the guarantor does not want to be fully liable for the loan.
According to the IRS, the bad boy guarantee “nonrecourse carve-out” provisions do not generally cause nonrecourse financing to be treated as recourse for tax purposes. Although the IRS did allow a bad boy guarantee of nonrecourse debt to be reclassified as recourse in 2016, it has since reconsidered the matter. In most circumstances, real estate partners can therefore continue to use bad boy guarantees as they traditionally have without the threat of reclassification from nonqualified financing to recourse financing.
If you have any questions or are concerned how a triggered bad boy guarantee may impact you, contact a member of the LaPorte Real Estate industry group. We are always happy to help.