Kuno S. Bell on How Best to Sell Your Ownership in a Rental Real Estate Partnership By Kuno S. Bell, Pease & Associates, Inc. 3.01 Introduction 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. Selling an asset and recognizing a gain or loss can be done in many different ways and each way has its own distinct tax results. When selling an asset, the seller s goal is usually to maximize his or her cash in pocket, taking into account all items, including taxes. There are basically two kinds of income and losses ordinary and capital. Ordinary income is taxed at the highest tax rate and ordinary losses can be used to offset all types of income. Long term capital gains are taxed at a lower tax rate. Capital gains, whether long term or short term, can be offset by capital loss carry forwards. IRC Section 1231, 1 deals with real property and depreciable personal property used in a trade or business. 2 This Code section was created to promote investment in depreciable property. 3 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. 4 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. 5 (Obviously, Section 1245, gain from dispositions of certain depreciable property, could apply in some cases, but this issue is beyond the scope of this review.) 6 Kuno S. Bell, C.P.A., J.D., is Director of the tax group at Cleveland, Ohio accounting firm Pease & Associates, Inc. 1 See 1 Thomas V. Glynn, Federal Taxes Affecting Real Estate, 6.01[4] (Matthew Bender, 6th Ed) for further discussion of IRC 1231 gains and losses. See also Lexis Tax Advisor Federal Topical, 1I:6.01[4]. 2 See Lexis Tax Advisor Federal Code, IRC 1231(b). 3 See 1 Thomas V. Glynn, Federal Taxes Affecting Real Estate, 5.01 and 5.02 (Matthew Bender, 6th Ed) for a discussion of the depreciation rules in a real estate context. See also Depreciation Handbook, Ch 10, (Matthew Bender, Rev. Ed); Lexis Tax Advisor Federal Topical, 1I:5.01 and 1I:5.02. 4 See Lexis Tax Advisor Federal Code, IRC 1231(a). 5 See Lexis Tax Advisor Federal Code, IRC 1231(c); Lexis Tax Advisor Federal Topical, 1I:6.01[4]. 6 See 1 Thomas V. Glynn, Federal Taxes Affecting Real Estate, 5.01 and 5.02 (Matthew Bender, 6th Ed) for a discussion of IRC 1245 depreciation and recapture. See also 1 Jerold Friedland, Tax Planning for Partners, Partnerships, and LLCs, 8.05 (Matthew Bender); Depreciation Handbook, Ch 10, (Matthew Bender, Rev Ed); Lexis Tax Advisor Federal Topical, 1I:5.01 and 1I:5.02.
A sale can be structured in many ways to generate a favorable tax result. Some of those ways are discussed below. 3.02 Section 1231 Loss Versus Capital Loss A person owns an interest in a partnership. The partnership owns depreciable real estate. 7 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, 8 the sale of a partnership interest 9 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. In an oversimplified form, under IRC Section 751, each partner is treated as if the partner owned his percentage interest directly in the partnership assets. 10 If the partner actually owned the assets and if the partner did sell those assets, IRC Section 751 converts the capital gain into ordinary income to the extent that a direct sale of the assets would generate ordinary income through Section 1245 depreciation recapture, through the sale of cash method receivables, through the sale of appreciated inventory, or through any other mechanism that classifies a gain on sale as ordinary income. However, no partnership Code section turns a capital loss into a Section 1231 loss. Therefore, the sale of the partnership interest in this example is a mistake. A much better result is for the partnership itself to sell the property. A sale of the property will produce the desired Section 1231 loss. The loss would then have the same benefits as an ordinary loss. 3.03 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. 11 However, some of the partners have reported significant Section 1231 losses in the prior 7 See 1 Thomas V. Glynn, Federal Taxes Affecting Real Estate, Ch 14 (Matthew Bender, 6th Ed) for a discussion of the use of partnership and LLC entities in real estate transactions. See also Lexis Tax Advisor Federal Topical, 1I:15. 8 See Lexis Tax Advisor Federal Code, IRC 741. 9 See 2 Jerold Friedland, Tax Planning for Partners, Partnerships, and LLCs, Ch 12 (Matthew Bender) for a discussion on the tax effects of selling a partnership or LLC interest. See also Lexis Tax Advisor Federal Topical, 2D:12. 10 See Lexis Tax Advisor Federal Code, IRC 751(a)-(f). 11 See 1 Thomas V. Glynn, Federal Taxes Affecting Real Estate, 6.01[4] (Matthew Bender, 6th Ed) for further discussion of IRC 1231 gains and losses. See also Lexis Tax Advisor Federal Topical, 1I:6.01[4].
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. As another example of this concept, a person who owns a multifamily residential rental building is looking to sell the building. The sale of the building is expected to produce a large gain. The gain would be reported as a Section 1231 gain and will potentially be taxed as a long term capital gain. However, the individual has reported significant Section 1231 losses in the prior five years. As a result of the Section 1231 recapture rules, a significant piece of the income would be treated as ordinary income. In lieu of selling the real estate, the individual should form an LLC, and contribute the property to the LLC. After some amount of time, the members of the LLC would sell all of their membership interests to a buyer. The sale would produce a capital gain pursuant to Section 741. There is no section like IRC Section 751 that converts capital gain into unrecaptured Section 1231 gain. The LLC would need to have at least two owners. If the individual is married, the spouse could be the second member. A child could be a second member, or a nongrantor trust, or a corporation. Because of the change in ownership, the IRS would be able to assert arguments challenging the valid existence of a partnership. Therefore, a proper business purpose and proper adherence to form are both highly recommended. Furthermore, the more time that passes between the LLC formation and the sale, the better. On the contribution of real estate to the LLC, if the contribution is completely tax free, then the LLC takes the property and continues the contributor s long term holding period. On the other hand, if the some of the contributed assets are short term assets, then part of the gain on sale of the partnership interests can potentially be converted to short term capital gain. Therefore, the LLC member should limit the assets being contributed to long term assets such as the building and land, and nothing more. 3.04 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. It appears that the Section 1231 recapture rules are computed on a taxpayer by taxpayer basis. A husband and wife are actually two separate taxpayers. If the husband in this example gifts to his wife the property expected to produce the Section 1231 gain before the sale occurs, then do his prior losses taint her gain and require her gain to be taxed as ordinary income? Would married filing separate in the year of sale be of assistance? 3.05 Tax on Unrecaptured Section 1250 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. 12 This particular gain is taxed as a long term capital gain but can be subjected to a higher federal tax rate of 25% instead of the usual 15% tax rate applied to long term capital gains. 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. Therefore, if a partner sells his partnership interest, a portion of the gain will be classified as unrecaptured Section 1250 gain. While this is still a long term capital gain, a higher tax bill could result. The taint of unrecaptured Section 1250 gain does not apply to a gain created by the redemption of a partner. Therefore, if a partnership is contemplating a sale of its depreciable real estate, the partnership should first consider redeeming as many partners as possible. The partnership would make a Section 754 election, 13 and adjust the basis under Section 734. 14 This is most likely to occur in a family partnership or a partnership where the partners have a good relationship with each other. The redemption could be paid for with existing partnership cash. If the partnership does not have cash, then the partnership would need new loans. Using an installment note to 12 See 1 Thomas V. Glynn, Federal Taxes Affecting Real Estate, 6.02[5] (Matthew Bender, 6th Ed) for a discussion of IRC 1250 depreciation and recapture. See also 1 Jerold Friedland, Tax Planning for Partners, Partnerships, and LLCs, 8.05 (Matthew Bender); Depreciation Handbook, Ch 10, (Matthew Bender, Rev Ed); Lexis Tax Advisor Federal Topical, 1I:6.02[5]; Lexis Tax Advisor Federal Code, IRC 1250(a)-(h). 13 See 1 Jerold Friedland, Tax Planning for Partners, Partnerships, and LLCs, 8.07 (Matthew Bender); Lexis Tax Advisor Federal Topical, 2D:8.07; Lexis Tax Advisor Federal Code, IRC 754. 14 See 1 Jerold Friedland, Tax Planning for Partners, Partnerships, and LLCs, Ch 8 (Matthew Bender); Lexis Tax Advisor Federal Topical, 2D:8; Lexis Tax Advisor Federal Code, IRC 734(a)-(e).
redeem a partner is also possible. But if the partners are related parties, then the basis rules related to installment sales between related persons need to be analyzed. Since this transaction has the effect of decreasing taxes, the IRS could challenge the redemption. Obviously the perfect situation would be where there is significant time between the redemption and the inking of the actual sale contract for the realty. 3.06 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. If the partner sells his or her partnership interest in lieu of waiting for the sale of the property, the gain on sale is in that case sourced to his or her resident state. This transaction can be done either by redeeming the partner s ownership interest before the sale or by structuring the sale of the real estate as a sale of 100% of the partnership interests. Picture a situation in which a partner would report $1 million of income if the partnership sold the property. All of that income is unrecaptured Section 1231 income, and the partnership does business in a state with an 8% tax rate. The partner lives in a state with no income tax. By redeeming the partner instead of waiting for the sale to play itself out, the partner has can potentially reduce his tax rate on the gain by 10 percent federal and 8 percent state for a combined 18% rate reduction (assuming a 25 percent tax on Section 1250 gain and no deduction value of the state taxes because the large gain instantly puts the taxpayer on the cusp of alternative minimum tax 15 ). On this $1 million gain, the partner has reduced his taxes by $180,000. 15 See 1 Thomas V. Glynn, Federal Taxes Affecting Real Estate, 6.01[9] (Matthew Bender, 6th Ed) for an overview of alternative minimum tax considerations related to real estate transactions. See also Lexis Tax Advisor Federal Topical, 1I:6.01[9], 1K:1-13. For a complete analysis of the alternative minimum tax, see the treatise, Lance W. Rook, Tax Planning for the Alternative Minimum Tax (Matthew Bender, Rev Ed).
3.07 Abandonment Versus Capital Loss or Section 1231 Loss An abandonment 16 of an asset can produce an ordinary loss. An abandonment does not give rise to a capital gain or loss because a capital gain or loss requires that something be sold. In an abandonment, since there is no sale, there cannot be a capital gain or loss. Certain Code sections prohibit treating certain capital assets as anything but capital gains or losses on disposition. For instance, publicly traded securities and the stock of corporations will always be treated as capital in nature. However, look at a situation where an LLC owns publicly traded securities that have significantly declined in value. If the owners abandon their LLC interests the loss would be ordinary. There is no look through provision to see what the LLC owns. The loss should be ordinary. 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. Please note that if the partner has any share of liabilities allocated to him, the abandonment will be treated as a sale. As a sale, the transaction will be classified as a capital gain or loss. 3.08 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 16 See 1 Thomas V. Glynn, Federal Taxes Affecting Real Estate, 6.04[1] (Matthew Bender, 6th Ed) for further discussion of abandonment of real estate. See also Lexis Tax Advisor Federal Topical, 1I:6.04[1].
account being zero. 17 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. Prior to the sale, each partner can make a decision. A partner can wait for the cancellation of debt income or the partner can abandon his ownership interest. Cancellation of debt income is reported as ordinary income. However, cancellation of debt income can be excluded from income if the individual partner is insolvent. If the liability was Qualified Real Property Indebtedness, 18 then, at the election of the partner, the income can be excluded from current income with the offset being a reduction to the basis of other real estate. A completely different result is achieved through an abandonment. When a partner abandons his ownership interest, the partner is treated as selling his ownership interest. This would create a capital gain. Treating this as a sale of the ownership interest brings a number of changes. The partner cannot exclude the income as cancellation of debt income as this is not cancellation of debt income. However, the capital gain is taxed at a lower tax rate than ordinary income from cancellation of debt income. Also, as previously discussed, the income could be moved out of a high tax state for state income tax purposes. Often when a taxpayer has negative tax equity, losses have been suspended due to either the passive loss limitations or the at risk limitations. 19 Suspended passive losses and suspended at risk losses can be deducted up to the amount of current income. This is true whether the current income is ordinary income, cancellation of debt income, or Section 1231 gain. Suspended losses can also be deducted to the extent of capital gain produced by the disposition of an interest in the activity. By abandoning an ownership interest, a taxpayer can generate a long term capital gain with an equal amount of ordinary loss becoming un-suspended. If the taxpayer has ordinary income from other sources, a taxpayer can generate a tax profit through taking advantage of the different tax rates a loss deducted against 35 percent income while paying tax at 15 percent. 17 For a discussion of cancellation of indebtedness income in a partnership situation, see 1 Jerold Friedland, Tax Planning for Partners, Partnerships, and LLCs, 3.03 (Matthew Bender). For a discussion of cancellation of indebtedness income in real estate transactions, see 1 Thomas V. Glynn, Federal Taxes Affecting Real Estate, 4.02[7], 12.10 (Matthew Bender, 6th Ed). See also Lexis Tax Advisor Federal Topical, 1A:8; Lexis Tax Advisor Federal Code, IRC 108(a)-(i). 18 See 1 Thomas V. Glynn, Federal Taxes Affecting Real Estate, 12.10 (Matthew Bender, 6th Ed). 19 See 1 Thomas V. Glynn, Federal Taxes Affecting Real Estate, Ch 13 (Matthew Bender, 6th Ed) and 1 Jerold Friedland, Tax Planning for Partners, Partnerships, and LLCs, Ch 6 (Matthew Bender) for a discussion of the passive activity, the at-risk, and other limitations. See also Lexis Tax Advisor Federal Topical, 1I:14.
If cancellation of debt income is expected, a married taxpayer can attempt to avoid paying tax on the income by moving the investment to his spouse. Cancellation of debt income can be excluded if the partner is insolvent. A partner is insolvent to the extent a partner s liabilities exceed the fair market value of the partner s assets. Determining a partner s liabilities is not so clear and straightforward. If a partner is personally liable on a debt, that liability is included in the measure of solvency. In the case of nonrecourse debt, the amount of the debt being forgiven is included in the measure of solvency but no other nonrecourse debt is considered. An additional tax consideration is that a sale by taxpayer to their spouse is not subject to income tax. The spouse takes the property with a carryover basis. In many marriages, one spouse will own most or all of the assets. The other spouse will own few assets or no significant assets at all. If it becomes clear that cancellation of debt income from nonrecourse debt is likely from a partnership, the spouse owning all the assets should transfer the partnership interest to the other spouse. The partnership will report the cancellation of debt income on a K-1 to the owner. The owner would then measure their individual solvency. To the extent their individual liabilities exceed their assets before the cancellation, that much of the cancellation income is not taxable income. The forgiven nonrecourse liability is included in the measurement of their pre-forgiveness liabilities. 3.09 Built in Losses 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. 20 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. 20 See 1 Thomas V. Glynn, Federal Taxes Affecting Real Estate, Ch 18 (Matthew Bender, 6th Ed) for a discussion of estate planning issues in real estate. See also Lexis Tax Advisor Federal Topical, 1I:19.
A taxpayer in such a case can try to gift the asset with the built in loss. However, in an overly simplified statement, the basis of an asset received in a gift is its fair market value. Therefore the loss cannot be gifted. In such a case the built in loss can be transferred through the use of a defective grantor trust sale. 21 The sale to a defective grantor trust is not classified as a sale since the trust is considered an extension of the taxpayer. Therefore, the basis limitation rules on gifts do not apply. The defective grantor trust properly drafted is not included in the grantor s estate. Since the asset is not included in the grantor s estate, the basis is not adjusted down to fair market value at death. At the death of the grantor, the trust ceases being a grantor trust. The trust is now a nongrantor trust. As a non-grantor trust, the trust can sell the asset and realize the loss. The loss can carry forward inside the trust. In the alternative, the trust can distribute the asset to the trust beneficiaries. The beneficiaries receive a carryover basis in the property. The beneficiaries can then sell the asset and claim the loss. Please note that if property s basis is less than the fair market value, then moving the asset into a defective grantor trust could potentially be a mistake. At death, the property would not benefit from the step up in income tax basis. Every situation comes with its own subtle differences in the fact pattern and those subtle differences can lead to totally different conclusions. 3.10 Conclusion There are many nuances in structuring a sale of depreciable real estate held by a partnership. Sometimes the difference is significant based simply on the choice of selling an asset versus selling partnership interests. At other times, some work may be necessary to restructure how an asset is held. All transactions are subject to the economic substance rules and potential penalties. Whenever possible, such restructurings should be planned for as many years in advance as possible. 21 See Lexis Tax Advisor Federal Topical, 3E:2.02 for a discussion of grantor and defective grantor trusts.