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PARTNERSHIP TAX TRAPS IN REAL ESTATE

DEVELOPMENT

Craig A. Taylor

Carruthers & Roth, P.A.

www.crlaw.com

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PARTNERSHIP TAX TRAP #1

SECTION 752 CONSTRUCTIVE DISTRIBUTIONS

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General Rules Increase in share of liabilities = constructive

cash contribution = increase in outside basis. §§ 752(a), 722.

Decrease in share of liabilities = constructive

distribution of cash = decrease in outside basis. §§ 752(b), 733.

If constructive distribution > outside basis then

must recognize gain under § 731.

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Possible Triggering Events

Contribution of encumbered property. Admission of a new partner. Abandonment or withdrawal by a partner

from the partnership. Reduction of a partner’s interest in the

partnership. Reduction in liabilities.

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Example A and B form an equal partnership. A contributes land with a fair market value of $180 on which there is a recourse mortgage of $80. AB assumes. A’s basis in the land is $30. B contributes $100 cash. AB assumption of the $80 mortgage increases B’s share of the partnership liabilities from $0 to $40 = $40 cash contribution = $40 increase in B’s outside basis. B’s outside basis = $140 ($100 cash contributed plus $40 net increase in liabilities). A has a net decrease in partnership liabilities of $40. A is given credit for her share of the partnership liability of $40. A’s basis in the land contributed was only $30. Deemed cash distribution of $40 exceeded her basis by $10, results in a $10 gain and a zero (0) outside basis.

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Example Partners A and B equally own a 100% interest in AB partnership. Partner C is admitted to a 40% interest in capital and profits.

Partnership has recourse liability of $1,000,000 and C assumes 40%. Immediately prior to C’s admission to the partnership, A and B each have an outside basis of $100,000. C’s debt assumption reduces A and B’s share of liabilities by $400,000 = deemed cash distribution to each of A and B totaling $200,000. After C’s admission, A and B each have a $100,000 taxable gain and an outside basis of zero.

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PARTNERSHIP TAX TRAP #2

DISGUISED SALES

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Background

Generally contributions of property to and distribution of property from a partnership are not taxable.

Section 707(a)(2) is designed to prevent sales of property between a partner and a partnership from being structured as nontaxable contributions and distributions under §§ 721 and 731.

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Rule

If the facts and circumstances indicate a sale has occurred, the transfers are treated as a sale or exchange between a partner and a partnership.

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Facts and Circumstances Test

Facts and Circumstances indicating sale include: Timing of subsequent transfer is

determinable. Obligation to transfer. Holding excess funds. Disproportionate dividends.

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The “Two Year Rule” Regs. create two alternative presumptions that will

determine the fate of most related transfers: 1. Transfers that occur within two years of

one another are presumed to constitute a sale.

2. Transfers separated by more than two years are presumed not to constitute a sale.

May rebut presumptions if circumstances clearly establish the contrary

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Example A contributes land with a FMV of $150,000 and a

basis of $100,000 to his partnership. In the same year, the partnership distributes $100,000 of cash and marketable securities worth $50,000 to A.

Per the two year rule, the transaction is presumed to be a disguised sale and Partner A will recognize a gain of $50,000.

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PARTNERSHIP TAX TRAP #3

SECTION 704(C)(1)(B) SEVEN RULE RULE

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General Rules Generally distributions of property made to a partner

do not result in gain or loss.

Section 704(c)(1)(B) provides that if property contributed by a partner with built-in gain or loss is distributed within a period of seven years after its initial contribution to any partner other than the contributing partner, the distribution is treated as if it were a sale.

Applies only to the contributing partner

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Gain Recognition

Contributing partner must recognize any gain inherent in the property at the time of contribution. Example: On formation of the ABC equal

partnership, A contributes land with a FMV of $100 and basis of $40. ABC distributes the land to C two years later when land is worth $130. A recognizes $60 of gain (the built-in gain).

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PARTNERSHIP TAX TRAP #4

SECTION 704(c) BUILT-IN GAINS AND LOSS

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General Rules Section 704(c) requires that tax items with

respect to contributed property must be shared to take into account the built-in gain or loss at the time of contribution.

Prevents the shifting of precontribution gains and losses among the partners.

Section 704(c) property defined. Property which, at the time of contribution, has a FMV (book value) that differs from the contributing partner’s adjusted basis (a “book/tax disparity”).

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Allocation Methods

Subject to the ceiling rule, partnerships can use any reasonable method to make contributing partner receive the tax benefits and burdens of any precontribution gain or loss.

Regulation methods Traditional method – Precontribution gain/loss

allocated to contributing partner. Traditional method with curative allocations – ceiling

rule fix Remedial allocaton – ceiling rule fix

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Example A and B form the AB equal partnership. A contributes land with a FMV $100 and $50 AB and B contributes $100 cash. Assets Liabilities/Partner’s Capital AB Bk. Value AB Bk. Value Cash $100 $100 A $50 $100 Asset $50 $100 B $100 $100 Total $150 $200 $150 $200

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Example (cont.)

Assume AB sells the land for $100. AB will have a $50 gain, which absent this section, would be allocated under the partnership agreement $25 to A and $25 to B, increasing their outside basis to $75 and $125, respectively. Results in a $25 shift of A’s precontribution gain to B.

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Example (cont.) We have a tax gain of $50 ($100 AR less $50 AB) and a book gain of $0 ($100 AR less $100 Bk. Value). Under s. 704(c), the $50 difference between tax and book is allocated to A leaving the following result: A B OB CA OB CA $50 $100 $100 $100 $50 ------ $100 $100 $100 $100

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Example

Assume same facts as prior example, except AB sells asset contributed by A for $110. Tax gain is $60 ($110 AR less $50 AB) and book gain is $10 ($110 less $100 BV). The $50 difference between the tax and book gain is allocated to A and the $10 book gain is allocated $5 to A and $5 to B. A’s OB would be increased by $55. Both A’s and B’s capital accounts would be increased by $5.

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Example (Ceiling Rule)

C and D form the CD equal partnership with C contributing land with a $20 FMV and a $24 AB and D contributing $20 cash. Assume CD sells the land for $22. CD’s tax loss is $2 ($22 less $24) and book gain is $2. The ceiling rule which limits 704(c) allocations to the tax gain or loss of the partnership. Thus, only a $2 loss (rather than $4) is allocate to A. Disparity between tax and book remains.

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Observations

Appraisal is critical when built-in gain or loss property is contributed to counter potential audits.

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PARTNERSHIP TAX TRAP #5

SECTION 737 SEVEN YEAR RULE (the “Mixing Bowl Rule”)

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General Rules

The s. 704(c) seven rule could be avoided if a partner contributing appreciated property could have the partnership distribute other property to the partner and cash out his interest.

Seven Year Rule. If a partner receives a distribution of property from a partnership within a seven year period of contributing appreciated property, the partner may be required to recognize gain.

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Gain Recognition The gain recognized will equal the lesser of:

(i) the fair market value of the property distributed less the distributee partner's outside basis, reduced by any money received, or

(ii) the partner's "net precontribution gain". Net precontribution gain = built-in gain that the partner has in all property that was contributed by the partner during the seven years prior to the distribution.

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Example

A and B form the equal AB partnership, with A contributing Gainacre (FMV $40, AB $24), and B contributing $10 cash and Land (FMV $30, AB $30). Three years later, when A’s AB is $24, AB distributes Land (FMV still $30) to A. A recognizes a $6 gain, the lesser of: (1) $6 ($30 value of Land less A’s $24 AB, or (2) $16, A’s net precontribution gain.

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PARTNERSHIP TAX TRAP #6

RECEIPT OF PARTNERSHIP INTEREST IN EXCHANGE FOR

SERVICES

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Current Rules

The taxation of the receipt of a partnership interest for services depends whether the interest is a “capital interest” or a “profits interest”.

Capital interest - entitles holder to a current claim on partnership net assets.

Profits Interest – No claim to current assets but entitled to future profits.

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Receipt of Capital Interest

Gross income to partner who receives if interest is transferable and not subject to risk of forfeiture.

Partnership receives deduction under s. 162.

If capital interest is subject to forfeiture, the receiving partner may make a s. 83(b) election and include in gross income the FMV of the interest at the time of transfer.

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Profits Interest Pursuant to Rev. Proc. 93-27, the receipt of a profits interest in

a partnership is not a taxable event so long as: 1. Receive the interest either as a partner or in anticipation

of becoming one; 2. The profits interest does not relate to a substantially

certain and predictable stream of income from partnership assets;

3. The partner does not dispose of the profits interest within two years of its receipt; and

4. The profits interest is not a limited partnership interest in a publicly traded partnership.

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Example A and B are equal partners in the AB partnership. Originally, A and B

each contributed $20,000 to the partnership, thus each has a $20,000 capital account. The fair market value of the partnership assets increase to $100,000 with a basis of $40,000. The partnership admits C as a 1/3 partner in the partnership. C will not be required to contribute any capital to the partnership for his interest.

Upon liquidation, C would receive a liquidating distribution of $20,000. (The first $40,000 would be distributed to A and B in accordance with their positive capital account balances, and the remaining $60,000 would be distributed equally to A, B and C.) Accordingly, the receipt of the partnership interest is a taxable event since the interest received by C was a "capital interest" and not merely a "profits interest."

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Example (cont.)

What if A & B are each to receive the first $50,000 in liquidation proceeds with the balance being distributed equally to all the partners, including C.

If the partnership assets were sold and the partnership liquidated immediately after C’s admission, C would not be entitled to any liquidation proceeds from the partnership.

C has received only a "profits interest“ – no income recognized

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Proposed Regs.

New Revenue Procedure found in Notice 2005-43.

If finalized, will render current rules obsolete – although in many cases, the ultimate result will be the same as under current law.

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THANK YOU!