The upshot for the commercial real estate industry is that if approach is adopted by the IRS it could force the conversion of billions of dollars in commercial real estate and CMBS loans from non-recourse to recourse, the Real Estate Roundtable concludes, creating huge unexpected tax liabilities for real estate investors.

“Nonrecourse carve-out provisions, including 'bad-boy' guarantees such as those analyzed in the IRS Chief Counsel Advice, play an important role in the financing of commercial real estate investment.,” Real Estate Roundtable CEO Jeff DeBoer told GlobeSt.com.

“For years, real estate investors have operated with the understanding that these guarantees do not change the nonrecourse nature of the underlying loans.”

As of right now DeBoer doesn't think the IRS plans to “change the basic rules of the road in this area,”.

The association will be working with the agency in the days ahead to clarify their intentions, he also said.

From the Beginning

A “bad boy” guarantee is a type nonrecourse carve-out (NRCO) provision that converts nonrecourse debt to recourse if a specific condition is met or not met. The “bad boy” NRCO bad-boy” guarantee protects a lender from voluntary bad acts by the borrower that would undermine the lender's ability to recover the loan.

Typical examples of such bad acts would be a voluntary bankruptcy, the borrower securing subordinate financing with the lender's consent or transferring the secured property without the lender's consent.

If one of these were to happen, and were covered as a bad act in the loan documentation, the loan becomes full recourse to the guarantor. Thus, the lender can collect from the guarantor's assets outside the partnership.

Now enter the taxpayer and its inquiry.

The basic facts the IRS was asked to consider were these: An LLC, treated as a partnership for tax purposes, and its subsidiaries borrowed funds from a lender on a non-recourse basis to support their real estate activities.

One of the LLC's members provided a customary carve-out or “bad boy” guaranty, which obligated him to repay the loan in full if any of the typical bad acts were to occur.

Essentially, the IRS' conclusion based on these facts undermines not one but two widely-held practices in CRE lending, according to a Kelley Drye client advisory published last month. One of the authors of the client note is Real Estate Roundtable Council Member Joseph Forte.

Kelley Drye wrote that the IRS concluded that:

A customary carve-out 'bad boy' guarantee given by an LLC member in connection with the LLC's real estate non-recourse financing was sufficient to cause the financing (a) to constitute a “recourse” liability for purposes of determining the members' tax basis in the LLC and (b) to fail to be a “qualified non-recourse financing” under the at-risk investment rules. As a consequence, the non-guaranteeing members of the LLC were deprived of the necessary tax basis and at-risk investment to claim losses from the LLC in excess of their capital contributions.

Retreat from Past Precedent

This thinking is almost an about face from precedent, RMS Partner Ed Decker and Principal Don Susswein wrote in their analysis of the IRS memo.

The bad boy scenarios are rarely violated, they note.

As a consequence, real estate partnerships and their tax advisors typically disregard these provisions when determining whether the related debt is considered to be recourse or nonrecourse with respect to its partners. Indeed, if a taxpayer inserted such a provision wishing it to be recognized by the IRS, in order to shift liabilities and tax basis to a party that did not truly bear any economic risk, the IRS would almost certainly argue that the provision should be disregarded because it is completely within the purported obligor's ability to control whether they breach their own promises. IRS regulations expressly provide that such “paper” promises should be disregarded. In this particular analysis, however, the IRS decided that the likelihood that the taxpayer would ever trip one of these provisions was not so remote as to be considered “likely to never be discharged” within the meaning of section 1.752-2(b)(4). As a consequence, the IRS concluded that the debt was recourse, entirely allocable to the guarantor.

The bottom line for the industry is that will not be pretty if this position becomes established law, Kelley Drye concluded. “Real estate investors would have to recapture billions of dollars in losses from previous years and could not share in losses in excess of their equity capital going forward,” it said.

Industry Push Back

Of course, it is a long way from one memo to established tax treatment.

The Real Estate Roundtable has created a working group for this issue and in fact plans to meet with the IRS this week on the issue, it reports.

It may be that the memo is being overly interpreted, according to the Kelley Drye attorneys.

At an industry event in February, an attorney-advisor for the Treasury Office of the Tax Legislative Counsel said that the memo was limited to the particular taxpayer to whom it was issued, they said. It was the attorney-advisor's “understanding that the IRS focus in the memorandum may have been on the specific carve-out exception relating to assignments made for the benefit of creditors or admitting to insolvency or inability to pay debts as they become due, although the memorandum did not focus its analysis on this carve-out.”

But if the industry is to assume the worse – that this view will be widely applied – there are a few counter measures to consider, none of which are entirely satisfactory.

Kelley Drye ended its client note with the following advice:

1. Investors could ignore the Memorandum on the theory that it is illogical, contrary to standard practice in the real estate financing market and unlikely to be sustained by the courts.

2. They could also pressure lenders to forego carve-out guarantees, “but that might be difficult since lenders also consider such guarantees to be standard industry practice.”

3. They could consider structuring guarantees that are arguably distinguishable from the IRS Memorandum, such as obtaining a guaranty from a non-member manager that has no interest in partnership or LLC profit and loss, “although since such a manager is likely to be an affiliate of a transaction party, this approach might be vulnerable.”

4. Or they could attempt to structure carve-out guarantees as being limited to the actual loss incurred by the lender resulting from the trigger event, rather than full recourse on the loan, which might result in only a portion of the loan being treated as a recourse liability. “Negotiating such a position, however, is unlikely to be successful, as lenders will insist on full recourse liability with respect to SPV violations, voluntary and collusive involuntary bankruptcy filings, and impermissible transfers and encumbrances of the secured property.”

WASHINGTON, DC—The Real Estate Roundtable is raising concerns about an internal memorandum written by the Internal Revenue Service's Office of Chief Counsel in October 2015 and released last month.

The memo was in response to a specific inquiry about a transaction that it very routine in the CRE industry – the tax treatment of so-called bad boy loan guarantees.

The IRS response was unexpected, to say the least, as it undercuts the long-held assumption in the industry that bad-boy guarantees do not change the nonrecourse treatment of the debt for tax purposes.

“IRS Chief Counsel Advice (CCA) 201606027 concluded that certain bad-boy guarantees effectively converted a nonrecourse real estate loan to a recourse loan,” the Real Estate Roundtable wrote in its analysis.

The upshot for the commercial real estate industry is that if approach is adopted by the IRS it could force the conversion of billions of dollars in commercial real estate and CMBS loans from non-recourse to recourse, the Real Estate Roundtable concludes, creating huge unexpected tax liabilities for real estate investors.

“Nonrecourse carve-out provisions, including 'bad-boy' guarantees such as those analyzed in the IRS Chief Counsel Advice, play an important role in the financing of commercial real estate investment.,” Real Estate Roundtable CEO Jeff DeBoer told GlobeSt.com.

“For years, real estate investors have operated with the understanding that these guarantees do not change the nonrecourse nature of the underlying loans.”

As of right now DeBoer doesn't think the IRS plans to “change the basic rules of the road in this area,”.

The association will be working with the agency in the days ahead to clarify their intentions, he also said.

From the Beginning

A “bad boy” guarantee is a type nonrecourse carve-out (NRCO) provision that converts nonrecourse debt to recourse if a specific condition is met or not met. The “bad boy” NRCO bad-boy” guarantee protects a lender from voluntary bad acts by the borrower that would undermine the lender's ability to recover the loan.

Typical examples of such bad acts would be a voluntary bankruptcy, the borrower securing subordinate financing with the lender's consent or transferring the secured property without the lender's consent.

If one of these were to happen, and were covered as a bad act in the loan documentation, the loan becomes full recourse to the guarantor. Thus, the lender can collect from the guarantor's assets outside the partnership.

Now enter the taxpayer and its inquiry.

The basic facts the IRS was asked to consider were these: An LLC, treated as a partnership for tax purposes, and its subsidiaries borrowed funds from a lender on a non-recourse basis to support their real estate activities.

One of the LLC's members provided a customary carve-out or “bad boy” guaranty, which obligated him to repay the loan in full if any of the typical bad acts were to occur.

Essentially, the IRS' conclusion based on these facts undermines not one but two widely-held practices in CRE lending, according to a Kelley Drye client advisory published last month. One of the authors of the client note is Real Estate Roundtable Council Member Joseph Forte.

Kelley Drye wrote that the IRS concluded that:

A customary carve-out 'bad boy' guarantee given by an LLC member in connection with the LLC's real estate non-recourse financing was sufficient to cause the financing (a) to constitute a “recourse” liability for purposes of determining the members' tax basis in the LLC and (b) to fail to be a “qualified non-recourse financing” under the at-risk investment rules. As a consequence, the non-guaranteeing members of the LLC were deprived of the necessary tax basis and at-risk investment to claim losses from the LLC in excess of their capital contributions.

Retreat from Past Precedent

This thinking is almost an about face from precedent, RMS Partner Ed Decker and Principal Don Susswein wrote in their analysis of the IRS memo.

The bad boy scenarios are rarely violated, they note.

As a consequence, real estate partnerships and their tax advisors typically disregard these provisions when determining whether the related debt is considered to be recourse or nonrecourse with respect to its partners. Indeed, if a taxpayer inserted such a provision wishing it to be recognized by the IRS, in order to shift liabilities and tax basis to a party that did not truly bear any economic risk, the IRS would almost certainly argue that the provision should be disregarded because it is completely within the purported obligor's ability to control whether they breach their own promises. IRS regulations expressly provide that such “paper” promises should be disregarded. In this particular analysis, however, the IRS decided that the likelihood that the taxpayer would ever trip one of these provisions was not so remote as to be considered “likely to never be discharged” within the meaning of section 1.752-2(b)(4). As a consequence, the IRS concluded that the debt was recourse, entirely allocable to the guarantor.

The bottom line for the industry is that will not be pretty if this position becomes established law, Kelley Drye concluded. “Real estate investors would have to recapture billions of dollars in losses from previous years and could not share in losses in excess of their equity capital going forward,” it said.

Industry Push Back

Of course, it is a long way from one memo to established tax treatment.

The Real Estate Roundtable has created a working group for this issue and in fact plans to meet with the IRS this week on the issue, it reports.

It may be that the memo is being overly interpreted, according to the Kelley Drye attorneys.

At an industry event in February, an attorney-advisor for the Treasury Office of the Tax Legislative Counsel said that the memo was limited to the particular taxpayer to whom it was issued, they said. It was the attorney-advisor's “understanding that the IRS focus in the memorandum may have been on the specific carve-out exception relating to assignments made for the benefit of creditors or admitting to insolvency or inability to pay debts as they become due, although the memorandum did not focus its analysis on this carve-out.”

But if the industry is to assume the worse – that this view will be widely applied – there are a few counter measures to consider, none of which are entirely satisfactory.

Kelley Drye ended its client note with the following advice:

1. Investors could ignore the Memorandum on the theory that it is illogical, contrary to standard practice in the real estate financing market and unlikely to be sustained by the courts.

2. They could also pressure lenders to forego carve-out guarantees, “but that might be difficult since lenders also consider such guarantees to be standard industry practice.”

3. They could consider structuring guarantees that are arguably distinguishable from the IRS Memorandum, such as obtaining a guaranty from a non-member manager that has no interest in partnership or LLC profit and loss, “although since such a manager is likely to be an affiliate of a transaction party, this approach might be vulnerable.”

4. Or they could attempt to structure carve-out guarantees as being limited to the actual loss incurred by the lender resulting from the trigger event, rather than full recourse on the loan, which might result in only a portion of the loan being treated as a recourse liability. “Negotiating such a position, however, is unlikely to be successful, as lenders will insist on full recourse liability with respect to SPV violations, voluntary and collusive involuntary bankruptcy filings, and impermissible transfers and encumbrances of the secured property.”