Partnership Tax Interactions

This chapter supplies the subchapter K machinery those two chapters assumed. It is not a treatment of partnership taxation, and it does not attempt to be. It sets out the provisions that actually operate in exchange transactions and identifies where each of them bites.

50.1 Why the partnership is the taxpayer

Two propositions from earlier chapters combine to create everything in this one.

A partnership interest is not real property and cannot be exchanged, as Chapter 13 and Chapter 21 develop. And the qualifying use requirement of Chapter 12 is applied to whoever holds the property, which where a partnership holds it is the partnership.

The consequence is that a partnership can exchange, and its partners cannot exchange their interests. A partner who wants out with cash and a partner who wants to defer are in genuine conflict, and the only resolutions are the ones examined at 20.3 and 20.4.

One escape exists and it is structural rather than transactional. An interest in a partnership that has in effect a valid election to be excluded from all of subchapter K is treated as an interest in each of the assets of the partnership rather than as an interest in a partnership.¹ Where that election is available and was made, the partners hold undivided interests in the underlying real property and each may exchange separately. The election's practical limits, and the reason it must be made at formation rather than at exit, are developed at 20.5.

A related structural fact deserves notice because it changed. A partnership is now considered terminated only if no part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership.² The former technical termination, which treated a partnership as terminating on a sale or exchange of fifty percent or more of the interests within twelve months, is gone. A transaction that shifts substantial partnership interests around an exchange no longer risks an inadvertent termination, which removes one complication that older planning materials still warn about.

50.2 Distributions and the drop

The drop and swap distributes property to partners who then exchange. Four provisions govern the distribution itself.

Gain on a distribution. Gain is not recognized to a partner on a distribution except to the extent any money distributed exceeds the adjusted basis of the partner's interest immediately before the distribution.³ A distribution of property, without money, ordinarily produces no gain.

Liabilities are money. Any decrease in a partner's share of partnership liabilities, or any decrease in the partner's individual liabilities by reason of the partnership assuming them, is considered a distribution of money to the partner.⁴ Any increase is considered a contribution of money.⁵ And a liability to which property is subject is, to the extent of the property's fair market value, considered a liability of the owner of the property.⁶

That trio is where the drop goes wrong. Distributing an encumbered property changes every partner's share of partnership liabilities. The distributee's individual liability increases, which is a deemed contribution, while the other partners' shares of the partnership's liabilities decrease, which is a deemed distribution of money to them. A partner with a low outside basis can recognize gain on a transaction in which nothing was sold and no cash moved.

The distributee's basis. In a non-liquidating distribution, the basis of distributed property is its adjusted basis to the partnership, capped at the adjusted basis of the partner's interest reduced by money distributed in the same transaction.⁷ In a liquidating distribution, the basis is the adjusted basis of the partner's interest reduced by any money distributed.⁸

The practical significance for an exchange is that the distributed property's basis is the number that then flows into Chapter 35. A partner whose outside basis is low takes a low basis in the distributed property, and the deferred gain the exchange preserves is correspondingly larger.

The seven year rules. Two provisions reach back at property that has moved through a partnership, and both should be checked before any drop is executed.

Where property contributed by a partner is distributed, directly or indirectly, to a partner other than the contributing partner within seven years of the contribution, the contributing partner is treated as recognizing the gain that would have been allocated under the contributed property rules if the property had been sold at fair market value at the time of the distribution.⁹

Where a partnership distributes property other than money to a partner who contributed appreciated property, that partner recognizes gain equal to the lesser of the excess of the fair market value of the property received over the partner's adjusted basis in the partnership interest reduced by money received, or the partner's net precontribution gain.¹⁰

Read together, those provisions mean that a drop executed within seven years of a contribution of appreciated property is a taxable event for someone, and identifying who requires knowing the partnership's contribution history. That history is often older than the current advisors, and it is the item most likely to be missing from the file.

50.3 Contributions and the exchange that precedes them

The mirror transaction contributes property into a partnership, and it arises in two ways in exchange practice. A taxpayer acquires replacement property and later contributes it to a venture. Or a partnership completes an exchange and then admits new partners.

The allocation rule follows the property. Income, gain, loss, and deduction with respect to property contributed by a partner must be shared among the partners so as to take account of the variation between the property's basis to the partnership and its fair market value at the time of contribution.¹¹

The consequence for an exchange chain is direct and is worth stating to any client contemplating a contribution. Replacement property acquired in an exchange carries a substituted basis far below its value, as Chapter 35 computes. When it is contributed to a partnership, that entire built-in gain is tracked to the contributing partner. The other partners do not absorb any of it, and the contributor's eventual share of gain on a partnership sale reflects the whole of the deferral accumulated across every prior exchange.

Two timing constraints follow from 50.2 read in reverse. A contribution starts a seven year clock. If the partnership distributes that property to another partner within seven years, the contributor recognizes gain. If the partnership distributes other property to the contributor within seven years, the contributor recognizes gain up to the net precontribution gain. A taxpayer who contributes exchange property to a venture has accepted a seven year constraint on how that venture may reorganize itself.

The holding requirement operates independently. A taxpayer who acquires replacement property and contributes it to a partnership shortly afterward has changed what the taxpayer holds, from real property to a partnership interest, and the question of whether the replacement property was held for productive use in a trade or business or for investment is the question Chapter 12 asks. The step transaction analysis of 42.1 applies to a contribution executed under the same plan as the acquisition, exactly as it applies to a distribution executed under the same plan as a disposition.

The counsel is symmetrical with 20.4. Where a contribution is contemplated, it should be separated in time from the exchange, supported by an independent business reason recorded when the decision is made, and not committed to in writing before the exchange closes.

50.4 Basis adjustments and the incoming partner

A partnership that has exchanged repeatedly holds property with a basis far below its value, and that fact governs what a new partner is buying.

The problem. A person who purchases a partnership interest pays fair market value for it and takes a cost basis in the interest. The partnership's basis in its property does not change. The new partner has therefore acquired a share of assets whose inside basis is far below what the partner paid, which means the partner will be allocated depreciation computed on someone else's low basis and will be allocated gain on a sale that the partner did not economically realize.

The remedy is elective. Where a partnership files an election, the basis of partnership property is adjusted, in the case of a distribution of property in the manner provided by one provision, and in the case of a transfer of a partnership interest in the manner provided by another. The election applies to all distributions and all transfers during the year for which it is filed and all subsequent years.¹²

Where the election is in effect, on a transfer of an interest by sale or exchange or on the death of a partner the partnership increases the adjusted basis of partnership property by the excess of the transferee's basis in the interest over the transferee's proportionate share of the adjusted basis of partnership property, or decreases it in the reverse case.¹³ The adjustment is made with respect to the transferee partner alone.

Three practical points.

The election is made by the partnership, not by the incoming partner, and it binds the partnership for all future years. An incoming partner who needs the adjustment must negotiate for it before closing, because after closing the partner has no ability to compel it.

The adjustment is mandatory without an election where the partnership has a substantial built-in loss immediately after the transfer.¹⁴ That rule protects the government rather than the taxpayer, and it does not help a partner buying into appreciated exchange property.

The interaction with the endgame of Chapter 46 is favorable and frequently overlooked. The adjustment applies on the death of a partner as well as on a sale. A partnership with the election in effect gives a deceased partner's successor an inside basis adjustment matching the outside basis adjustment under section 1014, which restores the depreciation the partnership had exhausted and eliminates the successor's share of the accumulated deferral. A partnership holding property that has been through several exchanges, with aging partners, should have the election in place. Making it is inexpensive; discovering after a death that it was never made is not curable.