Partner Loans in Real Estate Partnerships: Navigating Accrued Interest and Tax Implications

When a real estate partnership seeks to acquire a property, it's common for partners to be asked to contribute additional capital. However, if a partner prefers not to contribute more equity than required under the partnership agreement, they may instead opt to fund the acquisition through a loan to the partnership. While this can be an effective financing strategy, it also introduces important tax considerations, particularly regarding the accrual and deductibility of interest.

Understanding the Types of Partner Loans

In the context of partnerships, liabilities are categorized into three main types, each with distinct tax implications:

• Recourse debt: A partner bears an economic risk of loss and is personally liable for repayment. This type of debt increases the partner’s basis for both outside and at-risk limitations.
• Nonrecourse debt: No partner bears personal liability. The lender can only recover from the collateral that is typically the property, and the debt does not increase a partner’s at-risk amount.
• Qualified nonrecourse debt: This is specific type of nonrecourse debt is often secured by real property and commonly used in real estate, which does increase a partner’s at-risk basis under certain conditions.

Understanding how each debt type affects basis and loss deductibility is essential to proper tax planning.

Accrued Interest: Accrual-Basis Partnership and Cash-Basis Partner

Interest on partner loans is generally deductible to the partnership and includible in income by the lending partner. However, Sections 267 and 7872 of the Internal Revenue Code (IRC) impose limitations, especially when timing differences arise between accrual and cash basis taxpayers.

A key issue arises when an accrual-basis partnership incurs interest expense to a cash-basis partner. Under IRC Section 267, the partnership may not deduct the interest until the cash-basis partner includes it in income. This is typically when the interest is actually paid.

Example Scenario

Partner A, a cash-basis taxpayer, lends $400,000 to ABC Partnership (ABC), an accrual-basis real estate partnership, on May 1, 20X1. ABC uses the loan and $600,000 in capital contributions to purchase a property for $1,000,000. The loan carries 10% annual interest, payable on December 31 each year.

On December 31, 20X1, ABC accrues $40,000 in interest but does not pay it until January 4, 20X2. Because the payment was made in the following year, the deduction is deferred to 20X2 — the year in which Partner A, a cash-basis taxpayer, recognizes the income.

This rule prevents mismatched deductions and income recognition between related parties using different accounting methods.

Key Considerations and Best Practices

When analyzing partner loans and accrued interest, consider the following:

• Are interest payments or expenses owed to related parties (e.g., partners with a capital or profits interest): If so, confirm the accounting method of the partner receiving the payment. Additionally, the partnership may need to defer deductions if they are on a cash basis,.
• Are the partners themselves partnerships or entities: Entity-level partners may be on the accrual method, which could allow for interest deduction in the year accrued.

Summary

Accrued interest on partner loans may seem straightforward but can lead to unexpected tax timing issues if not carefully reviewed. Understanding the interplay between a partner’s tax method, the type of debt and applicable IRS rules is crucial in ensuring proper tax reporting and avoiding unnecessary deferrals.

If your real estate partnership has issued or received partner loans, or if you're navigating complex inter-partner transactions, our team can help you assess the proper tax treatment and avoid common pitfalls. Contact us to learn more.

Authored by Gustavo Gonzalez

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