Perfect Tax Shelters

Rental real estate partnerships organized in the 1980s supposedly embodied the perfect tax shelter: deferral of taxation, conversion of a portion of ordinary deductions into capital gain income, and the potential of high returns through appreciation and leveraging. However, TRA 86 substantially altered these strategies with the introduction of passive loss treatment and the elimination of preferential rate treatment for capital gains transactions. in today's real estate market, there are many investors holding limited partnership interests, where the value of the property in the partnership is significantly less than the nonrecourse debt encumbering it. If the property is given back to the lender through foreclosure or a deed in lieu, the recapture provisions generally create taxable gains. This tax time-bomb can be extremely substantial, depending upon the amount of deductions taken in excess of capital invested.

Partnership Liabilities

The tax law, through qualified nonrecourse borrowing, allows a real estate investor to deduct losses in excess of the cash contribution to a limited partnership. These losses taken in excess of an investor's cash investment must be recaptured as taxable income upon either a sale or foreclosure. This noncash income is referred to as "phantom income" and the tax liability created by phantom income is generally referred to as "tax recapture."

On a disposition of the partnership property, the amount realized includes the liabilities to which the property is subject. Reg. Sec. 1001-2(a)(1) treats a foreclosure transaction on property encumbered by nonrecourse debt as a sale. Furthermore, the fair market value of the partnership property will not be considered less than the nonrecourse debt encumbering the property for purposes of determining any gain or loss on sale Sec. 7701(g).

Example: In 1983, A and B formed XYZ real estate partnership with each contributing $10,000 and the partnership borrowing $80,000 (non- amortizing and nonrecourse) to purchase a building for $100,000. The operating expenses and debt service equal rental income; thus the partnership's taxable loss each year is equal to the depreciation expense of $7,000 per annum. On January 1, 1991, the fair market value of the property is $50,000 and the bank forecloses on the loan. A capital gain of $36,000 is recognized as a result of this disposition.

Nonrecoursedebt:$80,000

Costofproperty:$100,000

Less: depreciation -56,000 Basis of disposed

property 44,000

Capital gain on

disposition $36,000

Therefore, A and B each recognize a capital gain of $18,000.

Conversely, if A sold his interest for $1, the amount realized would include the relief of partnership liabilities. A gain of $18,001 would result, as the following tax analysis demonstrates:

Capitalcontribution$10,000

Allocatedlosses-28,000

Negotivecapitalaccount-18,000

Shareofliabilities40,000

PartnerA'staxbasis$22000

Gratuitous Transfers

Can a limited partner in a partnership avoid gain on the transfer of a partnership interest if the partner's share of nonrecourse partnership liabilities is greater than his basis?

Charitable Contributions. If a partnership interest is donated to a qualifying charity, a charitable contribution is allowed to the extent the fair market value exceeds its liabilities, which in turn exceeds the partner's basis in his interest Reg. Sec. 1.170A-1(c). Sec. 1011(b), however, treats the charitable gifts as a bargain sale to the extent liabilities are relieved and capital gain is recognized under Sec. 752(d). in the above example, Partner A's entire negative capital account of $18,000 would be recaptured as capital gain and there would be no charitable contribution deduction allowed. if the fair market value exceeded Partner A's share of the partnership's nonrecourse debt ($40,000), then a deduction would be computed for that excess using the rules under Sec. 1011(b).

The problem that exists in donating a partnership interest is whether a charity would accept the gift because the liabilities to which the real property is subject could be treated as acquisition indebtedness under Sec. 514(c). if so, any income generated by the partnership interest would subject the charity to tax under Sec. 512, as unrelated business taxable income.

Gifts. Comparable rules to that of charitable contributions apply. If the donor's share of partnership liabilities exceeds basis, then a deemed sale has occurred and capital gain is recognized. In the previous example, if A gifts his XYZ partnership interest to his son, no gift tax will result since the fair market value of the interest is zero. However, a capital gain would be recognized by A on the deemed sale. Unlike the bargain sale rules, no bifurcation of basis exists where the fair market value exceeds the liabilities assumed, but the gift portion would have a carryover basis to the donee.

Death of Partner. There is no provision in the code that requires a decedent's estate to treat the transfer of a partnership interest upon death as a transaction leading to relief of partner's liabilities. Therefore, Sec. 752(b) does not apply and no gain is recognized. Sec. 752(b) considers relief of liabilities as a distribution. To the extent a distribution exceeds a partner's basis, capital gain would be triggered pursuant to Sec. 731(a). Furthermore, Sec. 752(d) assures that the tax consequences are the same as those of other encumbered assets held by the decedent.

Pursuant to Sec. 2031, the value of property included in the gross estate is the fair market value of the property at the date of the decedent's death or alternate valuation date, if elected. Fair market value is defined as the price of the property that would change hands between a willing buyer and a willing seller. Therefore, applying the above example, Partner A's estate tax return would show a zero value for the partnership interest since liabilities exceed fair market value.

As to the beneficiary of A's interest, Sec. 1014(a) requires the basis of properly received from an estate to be its death value, net of liabilities. Since the partnership interest is essentially worthless, no step up of basis would occur.

Under Sec. 742, the basis of a partnership interest acquired from a decedent is the fair market value of the interest at the date of death, increased by the successor's share of partnership liabilities. In the case of A, his capital account is negative $18,000, but his share of partnership nonrecourse debt is $40,000. Therefore, his outside basis is $22,000 which is stepped up to $40,000 to reflect the successor's share of partnership debt allocable to that interest. Furthermore, if the XYZ partnership has a Sec. 754 election in effect, the successor partner can step up his inside basis of partnership property and take additional depreciation deductions based on his $18,000 step up. Caution must be taken in determining whether the partnership had any potential depreciation recapture property. The depreciation recapture would be considered an unrealized receivable under Sec. 751(c), and would be considered income in respect of a decedent under Sec. 691. Conversely, there would be a reduction in basis step up under Sec. 742.

The Final Stop to Tax Avoidance

While dying seems a bit drastic, it appears to be the only way to avoid the tax on recapture through gratuitous transfers. Keep in mind that other tax planning opportunities exist concerning tax shelter bailouts and must be reviewed.