Proposed disguised-sale regs. offer clarification and issues for real estate.

• Author: Bakale, Anthony S.

On Jan. 30, 2014, the Treasury Department issued new proposed regulations (REG-119305-11) intended to clarify the disguised-sale rules under Sec. 707 and the allocation of partnership liabilities under Sec. 752.

The existing final regulations under Sec. 707(a)(2) relating to disguised sales of property to and by partnerships were issued in 1992. In 2004, Treasury issued proposed regulations relating to disguised sales of partnership interests, but these were withdrawn in 2009. Treasury has not yet issued revised rules regarding disguised sales of partnership interests. However, the proposed regulations issued on Jan. 30, 2014, address concerns Treasury raised in the preamble to the 2004 proposed regulations. The following is a summary of the new proposed rules covering these concerns.

Under existing Regs. Sec. 1.707-3, a transfer of property to a partnership by a partner followed by a distribution of money or other consideration to the transferee will be treated as a sale of property by the transferee partner to the partnership if, based on all the facts and circumstances, the distribution by the partnership would not have occurred but for the transfer of the property by the transferee partner. Notwithstanding this general rule, the existing regulations contain several exceptions.

Debt-Financed Distribution Exception

Under the existing regulations, a distribution of money to a partner that is directly traceable to a partnership borrowing (incurred within 90 days of the distribution) will not be taken into account to the extent the borrowing does not exceed the transferee partner's share of the liability. The proposed regulations not only include an ordering rule, which applies the exception for debt-financed distributions before applying certain other exceptions to the disguised-sale rules, but also add an example to illustrate the debt-financed-distribution exception under the existing regulations when more than one partner receives all or a portion of the debt proceeds of multiple liabilities.

Under the debt-financed-distribution exception, if the partnership makes distributions under a plan to one or more partners from the proceeds of one or more liabilities, the exception treats all liabilities incurred as a single borrowing. In Prop. Regs. Sec. 1.707-5(g), Example (12), 0 transfers property X, and P transfers property Y, to OP Partnership. Subsequently, the partnership incurs two liabilities, Liability 1 of $8,000 and Liability 2 of $4,000. The partnership makes a distribution to 0 and P of $2,000 each. The distributions under Temp. Regs. Sec. 1.163-8T are traceable to either Liability 1 or Liability 2, previously incurred by OP Partnership. The liabilities are recourse liability of the partnership and are allocable to the partners pro rata, $4,000 and $2,000, respectively. In the example, Liability 1 and Liability 2 are treated as a single liability allocated $6,000 each to the partners.

For purposes of the exception, each partner's share of the liability is multiplied by a fraction, the numerator of which is the amount of the distribution traceable to the liability incurred and the denominator of which is the total liability incurred. Therefore, $2,000 ([84,000 4-$12,000] x $6,000) of the distribution is treated as being debt-financed and excepted from the transfer rule. This amount is deducted from the total distributions received by 0 and P to determine the amount subject to the rules of Regs. Sec. 1.707-3. The total transfer to each partner of $2,000 less the debt-financed amount of $2,000 equals $0 and is considered to be proceeds in a disguised sale of property to the partnership. Obviously, this example is overly simplified, but it provides a bright-line calculation to determine the amount to be taken into account in much more complex situations.

Preformation Expenditures

Another existing exception to the disguised-sale rules is for reimbursements of preformation expenditures (Regs. Sec. 1.707-4(d)). Under this exception, to the extent amounts distributed (transferred) by the partnership to the transferee represent reimbursement of certain capital expenditures incurred by the transferee partner during the 24-month period prior to the transfer, these amounts are...