In a previous post earlier this week, I described the proposed regulations under Section 752 of the Internal Revenue Code (the “Proposed Regulations”), and in particular, the proposed changes to the rules regarding the characterization of recourse and nonrecourse debt.

If enacted, the Proposed Regulations would have a significant impact on Low-Income Housing Tax Credit (“LIHTC”) transactions. LIHTCs are allocated to partners in the same manner in which they share the losses and depreciation deductions allocable to a partnership’s ownership of a qualified low-income building. The typical allocation scheme in which an investor partner is allocated 99.99% of each of these items will act to quickly reduce the investor’s capital account balance. Once the investor’s capital account balance is reduced to zero, it would only be able to continue to be allocated LIHTCs to the extent of its share of the partnership’s minimum gain attributable to nonrecourse liabilities, which is typically generated from depreciation deductions. Accordingly, LIHTC transactions are generally structured using nonrecourse debt to the greatest extent possible.

Given the relatively large appetite for nonrecourse debt in LIHTC deals, the Proposed Regulations would be positive to the extent that the complexity and subjective nature of the proposed recourse debt characterization rules makes it easier to classify debt as nonrecourse. However, there are certain circumstances in which it is preferable to characterize debt as recourse versus nonrecourse. For example, if a nonrecourse loan is made by a partner or a related person to a partner, only that partner (and not the investor partner) would be entitled to take into account the minimum gain generated by such loan. Because LIHTCs follow the allocation of losses and depreciation deductions among partners, minimum gain generated by a partner nonrecourse loan can result in a reallocation of LIHTCs away from the investor partner. In such a situation, it might be advisable to restructure the loan as recourse instead. Under the existing rules, this is relatively easy (e.g. by having the partner guarantee the repayment of the debt). However, re-characterizing the debt as a recourse obligation would be more difficult under the Proposed Regulations, as it would have be structured to meet the “seven commandments” and net worth tests described in my previous post.

The Proposed Regulations would certainly present new challenges for LIHTC deal structuring, but the strong preference for nonrecourse debt in LIHTC deals may help tax attorneys manage the impact of the Proposed Regulations better in LIHTC deals than in some other real estate investments.