Kuno S. Bell on How Best to Sell Your Ownership in a Rental Real Estate Partnership By Kuno S. Bell, Pease & Associates, Inc. § 3.01 Introduction The statement that you own real estate through a partnership and the real estate is going to be sold sounds quite simple. However, there are many nuances in the tax rules that can greatly alter the tax cost of the transaction. Selling an asset and recognizing a gain or loss can be done in many different ways and each way has its own distinct tax results. When selling an asset, the seller’s goal is usually to maximize his or her cash in pocket, taking into account all items, including taxes. There are basically two kinds of income and losses – ordinary and capital. Ordinary income is taxed at the highest tax rate and ordinary losses can be used to offset all types of income. Long term capital gains are taxed at a lower tax rate. Capital gains, whether long term or short term, can be offset by capital loss carry forwards. IRC Section 1231,1 deals with real property and depreciable personal property used in a trade or business.2 This Code section was created to promote investment in depreciable property.3 If depreciable property held more than a year is sold at a gain, then the gain is classified as a long term capital gain. If depreciable property is sold at a loss, then the loss is classified as an ordinary loss.4 However, something called unrecaptured Section 1231 loss recapture comes into play. Under the recapture rule, if a taxpayer has a Section 1231 gain, the gain is treated as ordinary income to the extent the taxpayer reported a Section 1231 loss in the prior five tax years.5 (Obviously, Section 1245, gain from dispositions of certain depreciable property, could apply in some cases, but this issue is beyond the scope of this review.)6 Kuno S. Bell, C.P.A., J.D., is Director of the tax group at Cleveland, Ohio accounting firm Pease & Associates, Inc. 1 See 1 Thomas V. Glynn, Federal Taxes Affecting Real Estate, § 6.01[4] (Matthew Bender, 6th Ed) for further discussion of IRC § 1231 gains and losses. See also Lexis Tax Advisor – Federal Topical, § 1I:6.01[4]. 2 See Lexis Tax Advisor – Federal Code, IRC § 1231(b). 3 See 1 Thomas V. Glynn, Federal Taxes Affecting Real Estate, §§ 5.01 and 5.02 (Matthew Bender, 6th Ed) for a discussion of the depreciation rules in a real estate context. See also Depreciation Handbook, Ch 10, (Matthew Bender, Rev. Ed); Lexis Tax Advisor – Federal Topical, §§ 1I:5.01 and 1I:5.02. 4 See Lexis Tax Advisor – Federal Code, IRC § 1231(a). 5 See Lexis Tax Advisor – Federal Code, IRC § 1231(c); Lexis Tax Advisor – Federal Topical, § 1I:6.01[4]. 6 See 1 Thomas V. Glynn, Federal Taxes Affecting Real Estate, §§ 5.01 and 5.02 (Matthew Bender, 6th Ed) for a discussion of IRC § 1245 depreciation and recapture. See also 1 Jerold Friedland, Tax Planning for Partners, Partnerships, and LLCs, § 8.05 (Matthew Bender); Depreciation Handbook, Ch 10, (Matthew Bender, Rev Ed); Lexis Tax Advisor – Federal Topical, §§ 1I:5.01 and 1I:5.02. A sale can be structured in many ways to generate a favorable tax result. Some of those ways are discussed below. § 3.02 Section 1231 Loss Versus Capital Loss A person owns an interest in a partnership. The partnership owns depreciable real estate.7 The fair market value of the real estate is lower than its undepreciated tax basis. A buyer has offered to buy all the partnership interests from all the partners. Because the fair market value is less than the undepreciated tax basis, the sale by each partner will produce a loss. According to IRC Section 741,8 the sale of a partnership interest9 produces a capital gain or loss. In certain circumstances, several Code sections convert a capital gain or loss into ordinary income or loss. The most notable of these is IRC Section 751. In an oversimplified form, under IRC Section 751, each partner is treated as if the partner owned his percentage interest directly in the partnership assets.10 If the partner actually owned the assets and if the partner did sell those assets, IRC Section 751 converts the capital gain into ordinary income to the extent that a direct sale of the assets would generate ordinary income through Section 1245 depreciation recapture, through the sale of cash method receivables, through the sale of appreciated inventory, or through any other mechanism that classifies a gain on sale as ordinary income. However, no partnership Code section turns a capital loss into a Section 1231 loss. Therefore, the sale of the partnership interest in this example is a mistake. A much better result is for the partnership itself to sell the property. A sale of the property will produce the desired Section 1231 loss. The loss would then have the same benefits as an ordinary loss. § 3.03 Section 1231 Gain Versus a Capital Gain Suppose a person has an interest in a partnership that owns a rental building. Also consider that the partnership is looking at a sale of the building. The gain on sale will produce a Section 1231 gain and would be expected to result in a long term capital gain.11 However, some of the partners have reported significant Section 1231 losses in the prior 7 See 1 Thomas V. Glynn, Federal Taxes Affecting Real Estate, Ch 14 (Matthew Bender, 6th Ed) for a discussion of the use of partnership and LLC entities in real estate transactions. See also Lexis Tax Advisor – Federal Topical, § 1I:15. 8 See Lexis Tax Advisor – Federal Code, IRC § 741. 9 See 2 Jerold Friedland, Tax Planning for Partners, Partnerships, and LLCs, Ch 12 (Matthew Bender) for a discussion on the tax effects of selling a partnership or LLC interest. See also Lexis Tax Advisor – Federal Topical, § 2D:12. 10 See Lexis Tax Advisor – Federal Code, IRC § 751(a)-(f). 11 See 1 Thomas V. Glynn, Federal Taxes Affecting Real Estate, § 6.01[4] (Matthew Bender, 6th Ed) for further discussion of IRC § 1231 gains and losses. See also Lexis Tax Advisor – Federal Topical, § 1I:6.01[4]. five years. Therefore, the gain for those partners would be treated as ordinary income subject to the highest tax rates. In this case, the partners should insist that the sale be structured as a sale of 100 percent of the ownership interests instead of a sale of assets. This will produce a capital gain under IRC Section 741. While there are Code sections that could convert the capital gain into ordinary income on the sale of the partnership interests, there is no look through rule that would convert a capital gain into a Section 1231 gain. As another example of this concept, a person who owns a multifamily residential rental building is looking to sell the building. The sale of the building is expected to produce a large gain. The gain would be reported as a Section 1231 gain and will potentially be taxed as a long term capital gain. However, the individual has reported significant Section 1231 losses in the prior five years. As a result of the Section 1231 recapture rules, a significant piece of the income would be treated as ordinary income. In lieu of selling the real estate, the individual should form an LLC, and contribute the property to the LLC. After some amount of time, the members of the LLC would sell all of their membership interests to a buyer. The sale would produce a capital gain pursuant to Section 741. There is no section like IRC Section 751 that converts capital gain into unrecaptured Section 1231 gain. The LLC would need to have at least two owners. If the individual is married, the spouse could be the second member. A child could be a second member, or a nongrantor trust, or a corporation. Because of the change in ownership, the IRS would be able to assert arguments challenging the valid existence of a partnership. Therefore, a proper business purpose and proper adherence to form are both highly recommended. Furthermore, the more time that passes between the LLC formation and the sale, the better. On the contribution of real estate to the LLC, if the contribution is completely tax free, then the LLC takes the property and continues the contributor’s long term holding period. On the other hand, if the some of the contributed assets are short term assets, then part of the gain on sale of the partnership interests can potentially be converted to short term capital gain. Therefore, the LLC member should limit the assets being contributed to long term assets such as the building and land, and nothing more. § 3.04 Section 1231 Losses Between Spouses The sale of depreciable real estate will generate Section 1231 gain. However, the taxpayer has significant unrecaptured Section 1231 losses in the prior five years. The effect of the unrecaptured Section 1231 losses will be to convert Section 1231 gain taxed as long term capital gain into ordinary income. A husband has reported Section 1231 losses in the prior five years. In the current year, he anticipates selling an asset and realizing a significant Section 1231 gain. The Section 1231 gain would be taxed as long term capital gain resulting in a much lower tax cost. However, due to his Section 1231 losses in the prior five years, his Section 1231 gain in the current year will be reclassified to ordinary income.