Real Estate Workouts—Holding or Selling Partnership Property
In a real estate workout involving a partnership or limited liability company (entity) consideration has to be given to either (i) continue holding the property in the entity or (ii) having the entity sell the property. The tax consequences of each action are considered below.
Hold the Property
Despite its cash flow problems, the entity may choose to hold on to the property in order to buy time for individual investor actions at the individual partner level. Such a technique allows the individual partners to choose the best time and most appropriate method for disposing of their interests.
It is likely that the entity will be generating phantom income after reaching the crossover point. In most cases, this income will constitute passive income under Section 469. If the existing partners are investors in other partnerships that are generating passive losses, this may be a desirable result because the passive phantom income being generated by the entity will be offset by the passive losses from the partnership. However, if this is not the case, the entity itself may attempt to shelter the passive income.
As a means of doing this, the entity could invest in other partnerships which are throwing off passive losses. This type of "pyramid scheme" may merely postpone the inevitable recognition of phantom income if the entity is sheltering phantom income with new leveraged investments, which will in turn create their own phantom income when the new investments reach the crossover point. The pyramid scheme could work, however, if a portion of the passive losses generated by the new investments are suspended by Section 469. These suspended losses could then be used in the future to offset any passive, phantom income generated by the new investments.
Taxable Sale of Property
If economically or commercially feasible, the entity may consider a sale of the underlying property. Such a sale may result in the recognition of a taxable gain or loss by the entity equal to the difference between the amount realized by the entity and its adjusted basis in the property.1 This taxable gain or loss will be passed through to the partners.2 The amount realized for purposes of determining gain or loss from the sale includes any cash and the fair market value (FMV) of any property received by the entity plus the amount of liabilities which the property is subject to or that are assumed by the purchaser of the property.3
Accordingly, if the liabilities encumbering the property exceed the adjusted basis of the property, the taxable gain recognized by the entity and passed through to the partners could exceed the amount of actual cash consideration received. As a result, the partners may not receive enough cash with which to pay the tax on their pro rata portion of the gain on sale that was passed through to them. Consequently, the partners will be required to recognize phantom income as a result of the transaction.
The character of the gain or loss recognized by the entity and passed through to the partners as a result of the sale depends on many factors. If the entity were deemed to be a dealer in the property sold, the gain would be characterized as ordinary income.4 In most cases, however, the character of the gain will be capital and will be recharacterized as ordinary income only to the extent of any depreciation recapture.
As a means of deferring gain recognition to the partners, the entity may consider making an "installment sale" of the underlying property. An "installment sale" is defined as any disposition of property where at least one payment is to be received after the close of the taxable year in which the disposition occurs.5 An installment sale does not include a disposition of personal property that is inventory in the hands of the selling taxpayer.6
Similarly, an installment sale does not include any dealer dispositions of real or personal property.7 A "dealer disposition" is defined as (1) any disposition of personal property by a person who regularly sells or otherwise disposes of personal property of the same type on the installment plan, and (2) any disposition of real property which is held by the taxpayer for sale to customers in the ordinary course of the taxpayer's trade or business.8 Consequently, if the entity is deemed to be a dealer in the property it wants to dispose of, the installment method will not be available to defer gain recognition.
Any income from an installment sale is accounted for under the "installment method." The installment method was enacted to allow a taxpayer to defer the recognition of income until the taxpayer receives the sales proceeds and has cash with which to pay the tax. Absent this statutory reprieve, the gain from the sale would ordinarily be taxable in the year the sale occurs, even though payment of part or all of the purchase price is deferred until future years. Accordingly, under the installment method, gain on a sale is generally reported ratably as each installment payment is received.9
The portion of each payment treated as income is determined by multiplying the payment received by a fraction known as the "gross profit ratio." The "gross profit ratio" is the ratio of the gross profit from the sale (the selling price less the seller's adjusted basis in the property) to the total contract price (the selling price for the property reduced by the lesser of (1) any qualifying indebtedness assumed or taken subject to by the buyer, or (2) the seller's adjusted basis in the property).10
Installment sales—ordinary income recapture. Notwithstanding the general installment sales rules, any "recapture income" must be recognized in the year of sale and any gain in excess of the recapture income will be taken into account under the installment method.11 "Recapture income" is defined as the aggregate amount which would be treated as ordinary income under the depreciation recapture rules of Code Sections 1245 and 1250 (or so much of Code Section 751 as it relates to Code Sections 1245 and 1250) in the taxable year of sale if all payments to be received were treated as being received in that year. Accordingly, the selling partnership and partners may be required to recognize a large amount of ordinary income in the year of sale if the property is almost depreciated without receiving enough cash to pay the related tax with.12
Passive loss considerations. Section 469 provides special rules with respect to the disposition of a passive activity. When an entity disposes of its entire interest in a passive activity to an unrelated party, such disposition triggers the realization of any suspended losses attributable to that activity by the partners.13 If a partnership is engaged in more than one passive activity, a taxable disposition of its entire interest in one activity will free up any suspended passive activity losses attributable to that activity. As a result, the partners will be able to use those losses to offset either their distributive share of any gain realized as a result of the disposition of the activity or any passive income being generated by the shelter's other activities.