When you are a partner in a partnership, you need to pay close attention to the Form K-1 that you receive at the end of the year. As it relates to partnership liabilities, there are three types to consider: (1) recourse; (2) nonrecourse; and (3) qualified nonrecourse financing. Much has been said and written about recourse and nonrecourse, so I won’t spend much time on this. But what is qualified nonrecourse financing? Let’s take a closer look at it along with some of the tax issues.
The definition of qualified nonrecourse financing is not that difficult to understand. It represents debt that is secured by real property that is used in the activity of holding real property. In most situations, this is property that is held for rental purposes. In addition, qualified nonrecourse financing represents financing for which no one is personally liable for repayment.
Accordingly, even in a pass through entity, the individual partner is not liable for payment of the debt (even if a default occurs). The following further outlines the requirements of qualified nonrecourse financing. It must be:
- borrowed by the entity in connection with the activity of holding real property;
- secured by real property used in the activity,
- not convertible from a debt obligation (a liability) to an actual ownership interest, and
- loaned or guaranteed by any government agency (federal, state, or even local) or loaned (borrowed) from a qualified person. A qualified person represents a person who is actively involved in and regularly engages in the business of lending money or providing financing. The most common example is a bank or savings and loan.
Qualified nonrecourse financing become very important as you take a closer look at basis and at risk limitations. These can be very important when trying to determine if a partner in a partnership can deduct a loss. Make sure that you take a close look at your K1 so that you get your basis calculations correct.