In year 3, when the building has a basis of $730 ($1,000 – $270), there is minimum gain of $70, because the principal balance of $800 exceeds the tax basis of $730. This minimum gain must be allocated $63 to A (90% * $70) and $7 to B (10% * $70), because that is how A and B were sharing the depreciation deductions that generated the minimum gain.
Of the $800 liability, $63 is allocated to A and $7 to B. As discussed below, the next step would be to allocate the remaining $730 of liability based on any Section 704(c) gain, but none is present in this scenario. As a result, the remaining $730 of liability would be allocated according to the profit ratio of 50/50, or $365 to A and $365 to B.
Step 2: Section 704(c) Gain
Under Step 2, if a partner contributed appreciated property to the partnership that secured the liability, the contributing partner must be allocated the liability to the extent of the excess of the liability over the tax basis at the time of the contribution.
Example: A and B form the AB, LLC on a 60/40 basis. A contributes land with a FMV of $100,000 and a tax basis of $25,000, secured by a nonrecourse $40,000 mortgage. B contributes $40,000 cash. If the property were disposed of for nothing but the relief of the nonrecourse liability, AB would recognize $15,000 of gain. This gain would all be allocated to A under Section 704(c). As a result, A should be allocated the first $15,000 of the nonrecourse liability with the remaining $35,000 allocated according to profits ratios, 60% to A and 40% to B.
Step 3: Profit Ratio
If there is no minimum gain or Section 704(c) gain, the allocation of nonrecourse liabilities is straightforward. If the loan was made directly by a partner or if the partner personally guaranteed the liability, that portion of the nonrecourse liability should be treated as a recourse liability and allocated specifically to that partner. Any remaining nonrecourse liability should be allocated according to the rules above. If there is no minimum gain or Section 704(c) gain to be allocated, the entire nonrecourse portion of the gain should be allocated according to the profits ratio.
Identify and Allocate Qualified Nonrecourse Debt
All liabilities allocated to a partner – both recourse and nonrecourse – increase the partner’s basis under Section 704. Nonrecourse liabilities, however, generally do not give the partner at-risk basis under Section 465. An exception is made, however, for amounts borrowed in connection with the activity of holding real property (think an LLC that owns commercial rental property).
Qualified nonrecourse liability is still a nonrecourse liability for Section 752 purposes, and must be allocated according to the rules discussed above.
After 4,000 words, what have we learned? Here are a few shortcuts:
- General partnership: all liabilities are recourse unless a debt is specifically nonrecourse at the partnership level. Thus, it will be rare to see a number on the “nonrecourse liability” line of Schedule K-1. Allocate according to hypothetical loss anlaysis.
- Limited partnership: all liabilities are recourse unless a debt is specifically nonrecourse at the partnership level, but only to the general partners. Allocate recourse liabilities solely to the general partners unless a limited partner has a DRO or guarantees the debt. Once again, it will be rare to have an allocation of a ”nonrecourse liability,” on Schedule K-1, and, it would follow, equally rare to have an allocation of any liability to a limited partner.
- LLC: all liabilities are nonrecourse unless personally guaranteed by a partner, made by a partner, or the partner enters into a DRO. If there is no guarantee, loan from a partner, or DRO, there should never be a recourse liability allocated on Schedule K-1.
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