New proposed regulations on tax-exempt real estate ownership.

In 1988, Congress directed the Treasury to formulate regulations under Sec. 514(c)(9)(E) on tax-exempt investment in real estate partnerships. The regulations were to be written with two goals in mind. First, the regulations were to eliminate the inconsistencies between the requirements of sub-clauses (I) and (II) of Sec. 514(c)(9)(E). Second, the regulations would limit the transfer of tax benefits from exempt partners to taxable partners who together invest in real estate partnerships. In 1990, the IRS issued Notice 90-41 to provide interim guidance and to request comments. On Dec. 30, 1992, the Treasury issued Prop. Regs. Sec. 1.514(c)-2.

Exempt organizations are generally taxable on their unrelated business taxable income (UBTI). A percentage of any gross income derived from debt-financed property is treated as UBTI. Sec. 514(c)(9) provides an exception for debt-financed investments in real property by qualified organizations, and Sec. 514(c)(9)(B)(vi) permits the ownership to be through a partnership, limited by Sec. 514(c)(9)(E).

Sec. 514(c)(9)(E) has two requirements: (1) The allocation of items to any partner that is a qualified organization cannot result in that partner having a share of overall partnership income for any tax year greater than that partner's share of overall partnership loss for the tax year for which that partner's loss share will be the smallest (the fractions rule). (2) Partnership allocations must comply with Sec. 704(b)(2) and the regulations thereunder.

For purposes of the fractions rule, overall partnership income or loss includes those items of income, gain, loss and deduction that increase or decrease the partner's capital accounts under Regs. Sec. 1.704-1(b)(2)(iv). To eliminate inconsistencies between the fractions rule and the Sec. 704(b) requirements, Notice 90-41 excluded several common allocations, such as guaranteed payments and preferred returns, from the computation of overall partnership income or loss. The proposed regulations clarify, change and add to the allocations and items that may be excluded from overall partnership income or loss, the most important addition being guidance for partnership chargebacks and qualified income offsets. The proposed regulations also provide rules for a change in interest, de minimis amounts and tiered partnerships.

The proposed regulations apply to partnerships organized, property acquired or interests acquired after Dec. 30, 1992. The fractions rule must be met annually and on a prospective basis in each year in which the partnership holds debt-financed property and has a qualified exempt and taxable partner; a change to a partnership agreement may cause the partnership to violate the fractions rule in the tax year of change and subsequent tax years.

Effectively, the proposed regulations are in addition to the Sec. 704(b) regulations. Both sets of regulations provide limitations on the allocation of partnership profits and losses. The proposed regulations go a long way in resolving the internal inconsistencies of Sec. 514(c)(9)(E). Further, the transfer of tax benefits from exempt to taxable partners appears to be limited. The result, however, is a very complex set of rules under which partnership agreements must be carefully written and reviewed; common partnership allocations and transactions can violate the fractions rule, even when the allocation or transaction does not appear abusive.