Allocating nonrecourse deductions - determining permissible sharing ratios.

• Author: Ellentuck, Albert B.
• Position: Analysis of hypothetical tax question

Facts

Judy and Sue form a partnership to invest in real property, and each contributes $1,000. The partnership then purchases rental real estate for $10,000, using the $2,000 cash and an $8,000 nonrecourse loan from an independent third party. The loan is secured by the property. The property is depreciable over 10 years using the straight-line method. The partnership's rental income equals its operating expenses, so there is a $1,000 net loss each year equal to depreciation expense. Judy could use tax deductions from the partnership, while Sue does not need them. They agree to allocate all losses 90% to Judy and 10% to Sue until such time as the property begins to make a profit. At that time, 90% of all profits will be allocated to Judy and 10% to Sue until the previously allocated losses have been charged back. After that point, profits will be shared equally. The partners anticipate that the project will be successful and that they will ultimately earn profits in excess of their investments. Subject to the requirements for liquidation of the partnership according to book capital accounts and the obligation to restore negative capital accounts, all cash flow is to be shared equally by Judy and Sue.

The partnership agreement complies with all the requirements of the safe harbor rules, and specifically includes a minimum gain chargeback provision.

Issue

Will Judy's and Sue's desired allocations be permitted? What other loss sharing allocation ratios would be allowable within the nonrecourse safe harbor provisions?

Analysis

Partnership losses are characterized as nonrecourse deductions to the extent of the increase in partnership minimum gain. Nonrecourse deductions must be allocated among the partners according to their partnership interests. The regulations also provide a safe harbor under which nonrecourse deductions can be allocated among the partners in a manner "reasonably consistent" with allocations of some other "significant partnership item" having substantial economic effect and related to the property securing the liability. To take advantage of this, the partnership agreement must comply with the safe harbor capital account maintenance requirements and must contain a...