What is the partner’s basis in the ownership interest following the transfer?
Under IRC Sec4on 722, the partner’s basis in the partnership acquired in exchange for property contributed to the partnership in an IRC Sec4on 721 transac4on equals the partner’s basis in the contributed property, plus any gain recognized. This is known as “outside basis”.
• Example: In the case of cliff above, Cliff’s basis in the partnership will equal his basis in the property contributed to the partnership. If Cliff’s basis in the property is lower than the value of the partnership interest received, Cliff may be able to recognize a gain on the transac4on. Any recogni4on of gain will raise Cliff’s basis in the partnership by that amount.
What is the partnership’s basis in the property following the transfer?
Pursuant to IRC Sec4on 723, the partnership assumes the basis of the transferring partner in the subject property, increased by any gain recognized by the partner in the transac4on. This is known as the “inside basis”. Unlike IRC Sec4on 351, IRC Sec4on 721 does not place limits on the ability to transfer property with a loss to the en4ty; however, the partner’s basis in the partnership can never go below zero.
• Example: In the case of Cliff above, the Partnership’s basis will equal Cliff’s basis in the property at the 4me of transfer. If Cliff recognizes gain on the transac4on, the partnership’s inside basis in the property will consist of Cliff’s basis, plus the gain Cliff recognizes on the transac4on.
What is the result if a partner receives some form of value in addi.on to an ownership interest?
Unlike IRC Sec4on 351, IRC Sec4on 721 does not permit the transfer of boot in the transfer of property to a partnership in exchange for an ownership interest. If a partner transfers property to a partnership in exchange for an ownership interest, the en4re transac4on will be treated as if it were a sale of the property to the partnership. Notably, in such a situa4on, the partner may recognize a loss on property transferred to the partnership. Loss recogni4on on the transac4on is not available, however, if the partner is a 50% or more owner of the partnership (this includes a holder of a 50% or great earnings interest). Further, if the property transferred to the partnership is something other than a capital asset or is a depreciable asset, then any gain recognized by the partner owning more than 50% in the transac4on will be taxed as ordinary income.
• Example: Garth transfers equipment to the partnership with a basis of $5,000 and a fair market value of $7,000. This transac4on would qualify under IRC Sec4on 721 and there is no recogni4on of gain. If, however, the partnership transfers a partnership interest worth $5,000 and a computer worth $2,000, the en4re transac4on will be treated as a sale of the property to the partnership. The transfer of the equipment will be treated as a sale and Garth will recognize a gain of $2,000 ($7,000 sale – $5,000 basis).
What happens if the partnership assumes shareholder debt associated with the transferred property?
The partnership may assume debt along with the transfer of property to the partnership. If the assump4on of debt reduces the partner’s obliga4on then the partnership’s assump4on of debt is treated as a payment of cash to the partner to the extent of her debt reduc4on. This lowers the partner’s basis. If the debt assumed is greater than the partner’s basis, she is taxed on the difference as a gain as if the property were sold for the amount of the assumed debt.
• Example: Victoria contributes property to the partnership with a basis of $5,000 in exchange for an interest in the partnership. The value of the property is $10,000 and there is an outstanding loan on the property of $10,000. The partnership assumes the $10,000 loan as part of the transfer of ownership. Victoria will recognize a gain on the transfer of $5,000. Victoria’s basis in the partnership will be $0 ($5,000 original basis – $5,000 debt assumed).
What happens if the partner contributes property to the partnership with gain that is later sold by the partnership?
As previously stated, the partnership’s basis in property received from a partner is the same as the partner’s basis. If the fair market value of the property is higher than the partner’s basis, then the gain in the value of the asset is not recognized. The partnership, however, must track the basis in the property for tax purposes. If the partnership later sells the property, it will have to report any amount of the sale above the basis in the property. The contribu4ng partner is allocated gain to the extent of the built-in-gain of the asset at the 4me the partner transferred it to the corpora4on. The tricky part of this situa4on is that the partnership may depreciate certain property each year. As previously stated, if property is sold for higher than the basis, the gain will be aFributed to the contribu4ng partner to the extent of the built-in-gain at the 4me of transferring it to the corpora4on. Due to the deprecia4on of the asset, the amount of gain aFributable to the partner equals the depreciated book value minus the depreciated tax basis.
• Example: Property with value of $300 and basis of $100 is contributed. The inside tax basis is $100. The contribu4ng partner’s inside built-in gain is $200 ($300 FMV – $100 basis). First year book value deprecia4on is $30 and tax basis deprecia4on is $10 (both are 10% of total). If the property is sold next year for $280, the total gain on the sale is $190 (280 sale price – 90 tax basis). Contribu4ng partner’s internal basis is $180 ($270 Book Value – $90 tax basis). Of the total gain, $180 is aFributed to contribu4ng partner. The other $10 of gain is distributed equally among all partners.
What happens if property contributed to the partnership is later distributed to other partners?
If property contributed by a partner is later distributed to a non-contribu4ng partner, it is treated as having been sold for its fair market value. This is true if the property is distributed within 7 years of the date it is contributed to the partnership. As in the above situa4on, any gain on the property will be aFributed to the contribu4ng partner to the extent of her built-in gain.
• Example: Bernice contributes property with a basis of $500 and a fair market value of $700 to the partnership. Bernice’s built-in-gains in the partnership is $200. If the property is later distributed to a partner for $800, the first $200 of gain is aFributed to Bernice. The remaining $100 gain is distributed equally among the partners.
How do partnerships allocate losses on the sale of property with a built-in-gain?
If property with a fair market value that is higher than the partner’s basis is contributed to the partnership, the partner has a built-in gain. If the partnership later sells the property for an amount that is less than the book value (fair market value at 4me of contribu4on – deprecia4on), then there is a book loss to the partnership. There is, however, s4ll a recognizable gain to the original partner if the sale price is above the partner’s tax basis. In this situa4on, there are two ways to allocate the gains and losses. First, the en4re gain (sale price – tax basis) can be aFributed to the contribu4ng partner. In this situa4on, the book loss is ignored. Second, the en4re built-in gain in the property can be aFributed to the contribu4ng partner (book value – tax basis). This amount will also equal the realized gain, plus the amount of book losses. Since the contribu4ng partner pays taxes on the en4re amount, the book losses can be distributed to the other partners.
- Example 1: Thomas, a partner, contributes property worth $300 with $100 basis to the partnership. The partnership’s inside basis is $100 equal to Thomas’ basis at the 4me of contribu4on. Aaer one year of deprecia4on (10% annual deprecia4on rate), the book value of the property is down to $270 and the tax basis is down to $90. That year, the property is sold for $240. This yields a gain of $150 ($240 sale price – $90 inside tax basis). The en4re $150 of gain is aFributed to Thomas, who has a built-in gain of $180 ($270 book value – $90 tax basis).
- Example 2: In the above scenario, the sale of the property yields a gain of $150, but a book loss of $30 ($270 book value – $240 sale price). If the property were sold at book value, the total gain would have been $180 ($270 book value – $90 tax basis). In such a situa4on, the partners may choose to allocate the en4re $180 hypothe4cal gain to the contribu4ng partner and split up the $30 loss between all partners.