Avoiding at-risk limits in real estate activities.

• Author: Ellentuck, Albert B.

Facts: Doug, Diane and Patty each plan to acquire a one-third ownership in an existing general partnership that owns and rents apartment buildings. Each partner will purchase a one-third interest from the existing partners on Feb. 8, 2004, for $25,000. The partnership originally acquired apartment buildings costing $1 million. The partnership has a $600,000 outstanding balance on a nonrecourse first mortgage secured by the properties. The loan is from a local bank that is not a "related party." The mortgage is payable in installments over 15 years at 10% interest.

The partnership plans to borrow an additional $325,000 from DT, Inc., a corporation 100% owned by Doug, to refurbish the properties. DT, Inc. is regularly engaged in the business of lending money. The note to DT, Inc. will be payable over 25 years at 3% and will be secured by a second mortgage against the properties. Each of the partners will be actively involved in the rental activities' management and day-to-day operations. None of the partners has adjusted gross income in excess of $100,000.

The properties were originally placed in service by the partnership in 1984. The partners anticipate heavy repair costs in 2004 and project a $75,000 tax loss for that year. In 2005, the partnership anticipates a $30,000 net loss for tax purposes. Each of the partners has substantial passive income from other rental properties. Issue: How should the financing be structured to maximize the deductibility of projected tax losses for 2004 and 2005? How much loss from the apartment rental activities will each of the partners be able to deduct in those two years? What amount does each partner have at-risk on Jan. 1, 2005 and 2006?

Analysis

Effective for tax years beginning after 1986, real estate activities became subject to at-risk limits on losses. In general, the at-risk rules apply only to properties placed in service after 1986. However, for interests in passthrough entities (such as partnerships and S corporations) acquired after 1986, the at-risk rules apply to all properties.

Except in the case of an activity of holding real estate, Sec. 465(b)(2)(A) and (b)(6) do not allow a taxpayer to include borrowings in amounts at-risk when the taxpayer is not personally liable for repayment. Similarly, Sec. 465(b)(2)(B) does not include borrowings in the amount at-risk if they are secured by property used in the activity. When Congress included real estate activities in the at-risk loss limits...