8934 / How are partnership losses and deductions attributable to nonrecourse obligations allocated among partners?

Special rules apply to the allocation of losses and deductions attributable to nonrecourse obligations after 1991. If, however, the partnership agreement has not been substantially modified after 1991, transitional rules may permit the use of the earlier regulations under certain circumstances.¹ See below for a discussion of the rules that applied prior to 1992.

For purposes of this discussion, the term “nonrecourse debt” refers to the traditional concept of nonrecourse—where a creditor’s right to repayment is limited to one or more assets of the partnership. Nonrecourse liability means partnership liability with respect to which no partner bears the economic risk of loss. If a partner bears the economic risk of loss with respect to nonrecourse debt, deductions and losses allocable to such nonrecourse debt must be allocated to such partner.² In contrast, recourse debt refers to debt for which an individual partner is liable.

Special rules have been developed to govern the treatment of nonrecourse liabilities in the partnership context, because an allocation of a loss or deduction attributable to the nonrecourse liabilities of a partnership (“nonrecourse deductions”) cannot have economic effect with respect to a partner. This is because it is the nonrecourse lender, rather than the partner, that bears the risk of economic loss with respect to the deductions.³ The amount of nonrecourse deductions for a partnership year is equal to the excess, if any, of the net increase in “partnership minimum gain” for the year over the amount of any distributions of proceeds of nonrecourse liabilities allocable to an increase in “partnership minimum gain.”⁴

“Partnership minimum gain” is the amount of gain which would be realized in the aggregate if the partnership were to sell each property that is subject to a nonrecourse liability for an amount equal to the nonrecourse liability.⁵

Generally, nonrecourse deductions will be considered to have been allocated in accordance with the partners’ interests in the partnership (and the allocation will therefore be honored), if the following requirements are met:

(1)  Nonrecourse deductions are allocated in a manner that is consistent with allocations that have substantial economic effect of some other significant partnership item attributable to the property securing the nonrecourse financing.

(2)  All other material allocations and basis adjustments either have economic effect or are allocated in accordance with the partners’ interests in the partnership.

(3)  The partners’ capital accounts are maintained properly.

(4)  Liquidation proceeds are required to be distributed based upon the partners’ capital account balances.

(5)  Following distribution of liquidation proceeds, partners are required to either (a) restore any deficits in their capital accounts to the partnership or (b) allocate income or gain sufficient to eliminate any deficit.

(6)  If there is a net decrease in partnership minimum gain during a year, each partner must be allocated items of partnership income and gain (“minimum gain chargeback”) for that year equal to that partner’s share of the net decrease in partnership minimum gain. (This requirement does not apply to the extent that a partner’s share of the net decrease in minimum gain is caused by a guarantee, refinancing, or other change in the debt instrument causing it to become partially or wholly recourse debt or partner nonrecourse debt, and the partner bears the risk of economic loss for the liability. Further, it does not apply to the extent that a partner contributes capital to the partnership to repay the nonrecourse liability and the partner’s share of net decrease in minimum gain results from the repayment).⁶

Years Beginning After December 29, 1988 and Before December 28, 1991

For those partnerships which qualified under the 1989-1991 rules and which choose to remain grandfathered under such rules, nonrecourse debt is treated under the rules described above.⁷ Nonrecourse deductions will be deemed to be allocated in accordance with the partners’ interests in the partnership if the requirements (1)-(4) and part (a) of the fifth of the requirements, described above, are met, and if the partnership agreement contains a clause complying with the minimum gain chargeback requirements contained in former Temporary Treasury Regulation Section 1.704-1T(b)(4)(iv). Those requirements provide that if there is a net decrease in partnership minimum gain during a year, each partner must be allocated a minimum gain chargeback equal to the greater of (1) the partner’s share of the net decrease in minimum gain attributable to a disposition of property securing nonrecourse liabilities, or (2) the partner’s deficit capital account.⁸

Years Beginning Before December 30, 1988

For partnerships which qualified under the rules that applied before December 30, 1988, and choose to remain grandfathered under such rules, nonrecourse debt is treated under the rules described in former Temporary Treasury Regulation Section 1.704-1T(b)(4)(iv),⁹ except that:

(1)  the amount of nonrecourse deductions for a partnership year is equal to the net increase in partnership minimum gain for the year. There is no reduction for certain distributions as there was under the former temporary regulations; and

(2)  nonrecourse deductions need not be allocated in accordance with the partners’ interests in the partnership if current requirements (1) through (4) are met and either: (1) following distribution of liquidation proceeds, partners are required to restore any deficits in their capital accounts to the partnership; or (2) if there is a net decrease in partnership minimum gain during a year, each partner must be allocated items of partnership income and gain for that year equal to that partner’s share of the net decrease in partnership minimum gain.