by Kuno S. Bell *
The statement that you own real estate through a partnership and the real estate is going to be sold sounds quite simple. However, there are many nuances in the tax rules that can greatly alter the tax cost of the transaction.
IRC Section 1231 deals with real property and depreciable personal property used in a trade or business. This Code section was created to promote investment in depreciable property. If depreciable property held more than a year is sold at a gain, then the gain is classified as a long term capital gain. If depreciable property is sold at a loss, then the loss is classified as an ordinary loss. However, something called unrecaptured Section 1231 loss recapture comes into play. Under the recapture rule, if a taxpayer has a Section 1231 gain, the gain is treated as ordinary income to the extent the taxpayer reported a Section 1231 loss in the prior five tax years...
A sale can be structured in many ways to generate a favorable tax result...
Section 1231 Loss Versus Capital Loss
A person owns an interest in a partnership. The partnership owns depreciable real estate. The fair market value of the real estate is lower than its undepreciated tax basis. A buyer has offered to buy all the partnership interests from all the partners. Because the fair market value is less than the undepreciated tax basis, the sale by each partner will produce a loss.According to IRC Section 741, the sale of a partnership interest produces a capital gain or loss. In certain circumstances, several Code sections convert a capital gain or loss into ordinary income or loss. The most notable of these is IRC Section 751...
Section 1231 Gain Versus a Capital Gain
Suppose a person has an interest in a partnership that owns a rental building. Also consider that the partnership is looking at a sale of the building. The gain on sale will produce a Section 1231 gain and would be expected to result in a long term capital gain. However, some of the partners have reported significant Section 1231 losses in the prior five years. Therefore, the gain for those partners would be treated as ordinary income subject to the highest tax rates.In this case, the partners should insist that the sale be structured as a sale of 100 percent of the ownership interests instead of a sale of assets. This will produce a capital gain under IRC Section 741. While there are Code sections that could convert the capital gain into ordinary income on the sale of the partnership interests, there is no look through rule that would convert a capital gain into a Section 1231 gain.
Section 1231 Losses Between Spouses
The sale of depreciable real estate will generate Section 1231 gain. However, the taxpayer has significant unrecaptured Section 1231 losses in the prior five years. The effect of the unrecaptured Section 1231 losses will be to convert Section 1231 gain taxed as long term capital gain into ordinary income.A husband has reported Section 1231 losses in the prior five years. In the current year, he anticipates selling an asset and realizing a significant Section 1231 gain. The Section 1231 gain would be taxed as long term capital gain resulting in a much lower tax cost. However, due to his Section 1231 losses in the prior five years, his Section 1231 gain in the current year will be reclassified to ordinary income.
Tax on Unrecaptured Section 1231 Depreciation
A partnership with depreciable real estate wishes to sell the real estate. The partnership has taken significant depreciation deductions on the realty. The transaction will then produce a significant Section 1231 gain.The portion of the gain attributable to the depreciation deductions is referred to as unrecaptured Section 1250 gain. The taint of unrecaptured Section 1250 gain applies to the gain created by the sale of the asset itself, as well as on the sale of a partnership interest in a partnership that owns depreciable real estate...
Re-Sourcing of State Income
A partnership owns depreciable real estate in a state with a high income tax rate. A sale of the real estate would require each partner to file and pay taxes to that high tax rate state. Some of the partners may not care because they live in states with high tax rates. They will claim the credit for taxes paid to other states and usually the credit will balance out the additional tax paid.However, an easy fact pattern is that someone invested in rental real estate in the state in which they lived and worked. Upon retirement, he or she moved to a state with either little or no income tax. Reporting income and paying tax to the state in which the depreciable real estate is located would simply be a dollar for dollar loss...
Abandonment Versus Capital Loss or Section 1231 Loss
Some taxpayers might want to take advantage of an LLC abandonment by moving their depreciated assets into a LLC and then abandoning the LLC. Obviously, the IRS would have reason to challenge this transaction if the formation of the LLC and the abandonment occur within a short time frame. The IRS could take the position that no legitimate partnership existed. If the partnership shell is thus removed, then this transaction is an abandonment of securities and produces a capital loss.There is no look through for a Section 1231 loss. Therefore, if an abandonment would generate an ordinary loss, no Code section would re-flavor the loss into a Section 1231 loss.
COD Income Versus Capital Gain
Suppose that an LLC owns rental real estate and has a liability secured by the real estate. Also consider that the real estate is worth less than the amount of the liability. The lender is making sounds about foreclosing on the security interest. The LLC can either sell the property or wait until the lender forecloses.If the LLC sells the property, the sale will generate either a Section 1231 gain or loss. The cash will be used to pay the secured lender. The balance of the unpaid liability will be treated as cancellation of debt income.Barring some unusual circumstance, the net amount of the Section 1231 income or loss combined with the cancellation of debt income will result in each partner's tax capital account being zero. Where a partner has a negative tax capital account this means that the partner took more losses and distributions than he reported income and took distributions. The negative tax capital can only come from losing or taking other people's money. When the partnership is relieved of paying back the liability, the partnership must recognize income – nothing is for free.
There are circumstances where a taxpayer would not receive a tax benefit from a loss. Furthermore, there are situations where a built in loss could disappear with no benefit. For instance, an 85 year old taxpayer in ill health owns an asset with a fair market value $5 million less than the tax basis of the asset.
The taxpayer can sell the asset and take the loss. However, it is quite possible for a taxpayer not to be able to benefit from the loss, e.g. a capital loss with no capital gain income resulting in a capital loss carry forward, or the loss far exceeds the taxpayer's other income and would result in a net operating loss carry forward. If the taxpayer dies before the carry forward losses are used, then the carry forwards simply disappear. Therefore, the potential tax asset is lost.Instead of selling the asset and creating an unusable loss, the taxpayer can continue holding the asset. If the taxpayer continues to hold the asset and dies, then the tax basis of the asset is stepped down to fair market value. The loss disappears before it was ever claimed...
Kuno S. Bell, C.P.A., J.D., is Director of the tax group at the Cleveland, Ohio accounting firm Pease & Associates, Inc.
LEXIS users can access the complete commentary HERE. Additional fees may apply (Approx. 12 pages)
RELATED LINKS: For further ciscussion, see:
1I Lexis Tax Advisor -- Federal Topical § 6.01 - Character of Gain or Loss
1I Lexis Tax Advisor -- Federal Topical § 15.01 – Partnerships and Limited Liability Companies
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