At-risk final regs. on "disqualifying interests".

• Author: Howard, B. Carol

Sec. 465 final regulations broaden the scope of the at-risk rules for loans from lenders with a "disqualifying interest" in the activity. Effective after May 3, 2004, amounts borrowed for use in essentially any activity will not increase the taxpayer's amount at ink, regardless of the taxpayer's personal liability for repayment, if the lender also has an interest in the activity other than that of a creditor (a disqualifying interest). The rules also apply if the lender is related to any person (other than the taxpayer) who has a disqualifying interest in the activity.

The final regulations apply to any individual or closely held corporation otherwise subject to the Sec. 465 at-risk rules; however, taxpayers who invest in passthrough entities may be affected the most, because they are likely to use borrowed funds to increase their at-risk basis for purposes of deducting allocated losses.

Overview

Prior to the issuance of the final regulations, Sec. 465(b)(3) (added in 1978) prohibited increasing an at-risk amount when funds were borrowed from lenders with disqualifying interests in the activity. However, at the time of passage, that provision applied only to activities enumerated in Sec. 465(c)(1) (motion pictures, farming, equipment leasing and the exploration/exploitation of oil and gas resources or geothermal deposits). For this ban to apply to "all other activities" the IRS was instructed to provide regulations. Proposed regulations (REG-209377-89) were finally issued in July 2003; final regulations were issued in April 2004 (TD 9124). Prior to that time, taxpayers engaging in any activity other than those enumerated in Sec. 465(c)(1) could increase their at-risk amount by borrowing funds from anyone, as long as the taxpayer/borrower was personally liable for loan repayment or had pledged assets as security. As was mentioned, the enumerated activities have been subject to Sec. 465(b)(3) all along.

Disqualifying Interests

General rules: Under Kegs. Sec. 1.465-8(b)(1), if a borrower is either personally liable for repayment of a loan or has secured it with assets with a readily ascertainable fair market value (FMV), a lender is deemed a person with an interest in the activity other than that of a creditor if he or she has either a Capital interest in the activity or an interest in the activity's net profits. For this purpose, [Legs. Sec. 1.4658(b)(2) provides that a lender has a capital interest in an activity if he or she is entitled to...