Investor Considerations for Real Estate Workouts
In a real estate workout involving a partnership or limited liability company (LLC) interest consideration has to be given to either (i) conveying the interest to the creditors of the entity or (ii) abandoning the interest. The tax consequences of each action are considered below.
Conveying to Creditors
An involuntary or voluntary conveyance of the interest will generally involve the same tax consequences of such a conveyance at the partnership or LLC level. Where an individual partner is personally liable with respect to any indebtedness of the partnership (i.e., in the case of recourse debt), an involuntary conveyance of his interest will produce cancellation of indebtedness income (COD Income) to the extent his relief from liability exceeds the fair market value (FMV) of his interest. The partner may, however, be able to avail himself of either the bankruptcy or insolvency exceptions to COD Income found in Section 108 to exclude all or a part of the COD Income from his gross income.
The applicability of these exceptions is determined at the partner rather than the partnership level. As a result, if a partner knows that he will fall within one of these exceptions, he can time his conveyance accordingly, but must be cognizant of the fact that certain of his other tax attributes will be reduced unless he elects to reduce his basis in depreciable property first.
Transferring the Interest to a Controlled Corporation. The transfer of a partnership or LLC interest to a controlled corporation attempts to shift the phantom income being generated to the corporation. There is the possibility of immediate gain recognition under either Section 357(c) (if the basis in the contributed interest is less than the liabilities transferred) or Section 357(b) (if the liabilities were assumed by the corporation to avoid federal income tax or without a bona fide business purpose).
In Noonan v. C.I.R.,1 the Tax Court disregarded a corporation formed solely to hold limited partnership interests where it was apparent that the corporation was not engaged in any business activity and was formed for the sole purpose of allowing the taxpayer to escape taxation.
For purposes of applying the rules of Section 357(c) to the transfer of partnership or LLC interests to a corporation in an exchange to which Section 351 applies, Revenue Ruling 66-1422 provides that in exchanges involving multiple transferors the provisions of Section 357(c) apply separately to each transferor. Thus, Section 357(c) gain to each transferor, if any, is the excess of the sum of the amount of his liabilities assumed over the adjusted basis of all property transferred by him pursuant to the exchange determined without regard to the adjusted bases and liabilities of any other transferor.
This concept was applied to the transfer of a partnership interest in Revenue Ruling 80-323,3 in which the limited partners of a motion picture partnership transferred their partnership interests to a corporation in exchange for the corporation's stock in a transaction that qualified under Section 351. In many instances, the share of nonrecourse partnership liabilities that had been allocated to a limited partner pursuant to the Section 752 regulations exceed the limited partner's adjusted basis in his partnership interest. The IRS ruled that each partnership interest exchanged for the stock of the new corporation was subject to its share of partnership liabilities as determined under Section 752 and that Section 357(c) gain would be recognized to each transferor partner to the extent that each partner's share of partnership liabilities exceeded his adjusted basis in the partnership interest transferred.
In Technical Advice Memorandum 87150003 (Nov. 7, 1986), partners in several partnerships transferred their interests in the partnerships along with their share of the partnership liabilities of those partnerships to a corporation in a transaction to which Section 351 applied. The IRS ruled that for purposes of determining gain under Section 357(c) for each transferor partner that transferred his partnership interests and liabilities, the amount of gain equaled the excess of that transferor partner's total share of all liabilities (assumed or taken subject to) transferred in the transaction over the total adjusted basis of all the property (including the partnership interests) transferred by that transferor partner. Accordingly, the sum of a transferor partner's share of liabilities of several partnerships assumed must be compared to the sum of the transferor partner's basis in his or her several partnership interests transferred for purposes of computing gain under Section 357(c).
A partner or member in a financially troubled real estate entity who will recognize a capital loss if the property is foreclosed on, and the partnership or LLC subsequently liquidated, may be able to avoid the limitations on deducting capital losses by abandoning his interest prior to the foreclosure. Such a result is possible if there is neither an actual nor a constructive distribution to the partner or LLC member as a result of the abandonment.4
In order to claim an abandonment loss, a taxpayer must manifest an intent to abandon his interest by some overt act or statement reasonably calculated to give a third party notice of the abandonment.5 In Echols v. C.I.R., a taxpayer owned a limited partnership interest in a partnership whose sole asset was an unimproved tract of land. The land was encumbered by a nonrecourse mortgage which was greater than the land's FMV. The partnership attempted to restructure its nonrecourse debt, but failed and the land was subsequently foreclosed on by the lender. In the taxable year preceding the foreclosure, the taxpayer called a meeting of the partners and announced that he was walking away from his partnership interest and that he would no longer contribute his share of additional funds needed by the partnership for the nonrecourse mortgage and ad valorem tax payments due on the land.
The U.S. Court of Appeals for the Fifth Circuit, reversing the Tax Court, held that the taxpayer's declarations, coupled with his overt acts, were more than sufficient to constitute an abandonment of his partnership interest for which he could claim a loss pursuant to Section 165(a). In addition, the Fifth Circuit found that the taxpayer had demonstrated the "worthlessness" of his partnership interest during the taxable year and that, alternatively, the taxpayer could claim a loss for such interest under Section 165(a) relying on that ground as well.
Similarly, in Citron v. C.I.R.,6 the taxpayer was a limited partner in a motion picture partnership. After production of the movie, the partnership could not obtain the completed film from the producer. The taxpayer was advised that an expensive and lengthy lawsuit would have to be brought against the producer in order to recover the film. In addition, it was suggested that with additional investment an X-rated version of the movie could be made from prints that might allow the recovery of a portion of taxpayer's investment in the partnership.