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Major References: I.R.C. 465(b)(6); Regs. 1.465-27.
INTRODUCTION
The use of nonrecourse financing has long been an integral component of the real estate sector. Such financing, however, has fueled a variety of "tax shelter" investments, some of which the IRS and the courts have deemed abusive.
In an effort to curtail abuses of nonrecourse financing (as well as other tax shelter devices), Congress in 1976 enacted the at-risk rules of 465. However, the real estate sector initially received preferential treatment under the at-risk rules; the activity of holding real property was excepted from the rules. This left the IRS to resort to the courts to combat abusive uses of nonrecourse financing.
In 1986, recognizing that previous measures were unsuccessful in stemming the tide of tax shelters, Congress extended the at-risk rules to the activity of holding real property. However, Congress provided a significant exception to such treatment in the form of the qualified nonrecourse financing rules, which, if certain conditions are satisfied, accord at-risk status to real estate activities funded by nonrecourse financing.
This memorandum examines the evolution of the at-risk rules as they relate to real estate, with particular emphasis on the qualified nonrecourse financing rules. The memorandum first provides some background information concerning the evolution of the at-- risk rules, and discusses a recent proposal to repeal (sec) 465(b)(6). The memorandum then examines the final regulations recently issued under (sec) 465(b)(6). Although the regulations do not address all of the issues arising under the qualified nonrecourse financing rules, they provide helpful guidance, particularly in the case of qualified nonrecourse financing of partnerships and limited liability companies.
PROLOGUE: REAL ESTATE AND NONRECOURSE DEBT: JUDICIAL CONSTRAINTS
Prior to the extension of the at-risk rules to real estate, courts considered various challenges by the IRS to "tax shelter" investments involving the purchase of real estate with nonrecourse debt. In Mayerson v. Comr.,1 a taxpayer purchased depreciable property under a purchase money mortgage note where the principal balance was not due and payable for 99 years. The IRS made the following alternative arguments: (i) the transaction was, in substance, a lease with an option to purchase; (ii) no depreciable basis was created because the mortgage was contingent and indefinite; and (iii) no depreciable basis was created...