1.704-2: Allocating Partnership Nonrecourse Liabilities

When a partnership has debt for which no partner is personally liable, special tax rules apply. Treasury Regulation §1.704-2 provides a comprehensive framework to ensure the allocation of deductions from this nonrecourse debt is recognized for tax purposes. These regulations are based on the principle that tax consequences should follow economic reality.

Since nonrecourse deductions are funded by the lender who bears the ultimate risk of loss, they lack the “substantial economic effect” required for other partnership allocations. Instead, the regulations establish a specific safe harbor that validates the allocation of these deductions by aligning them with the partners’ broader interests in the partnership.

Core Concepts of Partnership Nonrecourse Liabilities

A nonrecourse liability is a debt for which no partner or related person bears the economic risk of loss. Should the partnership default, the lender’s only recourse is to seize the property securing the loan; the lender cannot pursue any partner’s personal assets for repayment. This structure isolates the financial risk to the collateral.

This leads to the concept of “partnership minimum gain,” which is the taxable gain the partnership would realize if it disposed of the property subject to the nonrecourse debt for no consideration other than satisfying the liability. The calculation is the amount of the nonrecourse liability minus the property’s adjusted book basis. For instance, if a partnership owns a building with an adjusted basis of $700,000 that secures a $1,000,000 nonrecourse loan, the partnership minimum gain is $300,000.

A partnership must calculate its minimum gain at the end of each year and compare it to the amount from the prior year to determine if there has been a net increase or decrease. An increase in partnership minimum gain during the year gives rise to “nonrecourse deductions.” These are the partnership’s losses and deductions, most commonly depreciation, that are attributable to the nonrecourse liability. The total amount of nonrecourse deductions for a given year is equal to the net increase in partnership minimum gain for that year.

Allocating Nonrecourse Deductions

For the IRS to respect a partnership’s allocation of nonrecourse deductions, the allocation must satisfy a four-part safe harbor test outlined in these regulations. Meeting these requirements ensures the allocations are deemed to be in accordance with the partners’ interests. Failure to comply means the IRS can reallocate the deductions based on its own determination of the partners’ overall economic arrangement.

The test has four requirements:

• The partnership must comply with the general rules for maintaining capital accounts throughout its life, as detailed in Treasury Regulation §1.704-1. This includes properly crediting and debiting partner accounts and requiring that liquidating distributions follow positive capital account balances. It also requires that partners with a deficit balance must restore it.
• The allocation of nonrecourse deductions must be “reasonably consistent” with allocations of some other significant partnership item attributable to the property securing the debt. This other item must have substantial economic effect. For example, if a partnership allocates operating income 90/10, allocating nonrecourse deductions 50/50 would likely not be considered reasonably consistent.
• The partnership agreement must contain a “minimum gain chargeback” provision, a mechanism designed to reverse the benefit of prior nonrecourse deductions when the underlying minimum gain decreases.
• All other material allocations and capital account adjustments of the partnership must be recognized as valid.

The Minimum Gain Chargeback Requirement

The minimum gain chargeback is a provision in a partnership agreement that reverses the tax benefit of nonrecourse deductions previously allocated to a partner. The chargeback is triggered when there is a net decrease in partnership minimum gain during a taxable year. This decrease often occurs when the partnership pays down the principal of the nonrecourse debt or when the property securing the debt is sold.

When a net decrease in minimum gain occurs, the chargeback rule requires the partnership to allocate items of income and gain to the partners who were previously allocated nonrecourse deductions. Each partner must be allocated income equal to their share of the net decrease in partnership minimum gain. This ensures that the partners who benefited from the deductions that created the minimum gain are the same partners who recognize the income when that minimum gain is reversed.

Consider a partnership that sells a property with a $650,000 adjusted basis for $1,200,000, using the proceeds to repay the $1,000,000 nonrecourse loan. The sale eliminates the partnership’s minimum gain of $350,000. This net decrease triggers the chargeback, and the partnership must allocate the first $350,000 of its gain from the sale to the partners in proportion to their prior allocations of nonrecourse deductions.

The regulations provide exceptions where a minimum gain chargeback is not required. A chargeback is not triggered if a partner contributes capital to the partnership, and that capital is used to repay the nonrecourse debt or increase the basis of the property securing it. Another exception applies when a nonrecourse liability is converted or refinanced into a recourse liability, as the economic risk has shifted to the partners.

Rules for Partner Nonrecourse Debt

“Partner nonrecourse debt” is a liability that is nonrecourse for the partnership, but for which a specific partner individually bears the economic risk of loss, such as through a personal guarantee. For the other partners, the debt is nonrecourse, but for the guaranteeing partner, it is effectively a recourse obligation.

Deductions attributable to this debt, known as “partner nonrecourse deductions,” must be allocated entirely to the partner who bears the economic risk of loss. This is because that partner would suffer the financial consequences if the partnership failed to pay the debt.

“Partner nonrecourse debt minimum gain” is calculated for each specific partner nonrecourse debt. It is the gain that would be realized if the partnership disposed of the property subject to that debt in full satisfaction of the liability. This calculation is tracked on a debt-by-debt and partner-by-partner basis.

A minimum gain chargeback also applies to partner nonrecourse debt. When a net decrease in the partner nonrecourse debt minimum gain occurs, partnership income and gain must be allocated back to the specific partner who was originally allocated the deductions.