This column continues the discussion of the tax issues resulting when a loan secured by real property defaults (Troubled Loan). A Troubled Loan may be restructured or worked out. In many cases, the owner may be unable or unwilling to provide additional equity to the property secured by the Troubled Loan. The owner often desires to maintain ownership of the troubled properties while avoiding substantial payments of tax to the Internal Revenue Service (IRS) in connection with a restructuring or workout that does not generate any significant cash. This column will discuss the key issues that a partnership that owns a troubled property faces when admitting new partners as part of the restructuring of the property and Troubled Loan.

The admission of additional partners to the partnership provides immediate cash to eliminate cash flow problems. The admission of new partners is normally only a temporary measure to prevent the immediate loss of the property and should be attempted only when a turnaround is likely or when temporary financial stability is needed. Where bad management is the primary reason for the failure of the property and the probability of a turnaround is low, however, the admission of new partners may only result in delaying the foreclosure with additional investors who may later seek legal remedies against the partners.

Deemed cash distributions may occur. The existing partners will be treated as receiving a cash distribution to the extent that they experience a relief of their pro rata share of the partnership’s debt.1 If this distribution is in excess of their adjusted basis in their partnership interest, they will recognize gain, but will not receive any cash from the partnership in order to pay the tax on such gain.2 Consequently, the existing partners may recognize "phantom income" as a result of the admission of additional partners and may resist the use of this technique. Such resistance may prove fatal because some partnership agreements require the approval of the existing partners prior to the admission of new partners. If such approval cannot be obtained, admission of new partners will not constitute a viable alternative.

If the new money is not used to pay down existing partnership nonrecourse debt, the existing partners can avoid recognizing phantom income under the Section 752 regulations.3 Conversely, if the new money is used to reduce existing partnership nonrecourse debt, there will be a Section 752(b) deemed distribution and a reduction in partnership minimum which may result in a minimum gain chargeback. The minimum gain chargeback may be avoided by booking-up the partnership’s assets as discussed below.

Section 751. In addition, potential problems may exist under Section 751(b) to the extent that there is a change in the partners’ share of partnership liabilities. In Revenue Ruling 84-102,4 decrease in an existing partner’s profit-sharing ratio combined with a corresponding decrease in his share of partnership liabilities as a result of the admission of a new partner was ruled to be a deemed sale of a portion of his share of the partnership’s unrealized receivables and substantially appreciated inventory items (commonly referred to as Section 751(b) "hot assets") under Section 751(b)(1)(B). Consequently, the existing partner was required to recognize ordinary income rather than capital gain as a result of the admission of the new partners.

Restructuring with either new partner or creditor. Instead of a workout agreement that just modifies the Troubled Loan, the partnership may be restructured with a new partner or partners being admitted. The new partner may be a third party who contributes cash which is used to pay down part of the Troubled Loan balance or agrees to contribute or loan cash to the partnership used by the partnership to satisfy its debt service obligations. Another option is for the partnership’s creditor to be admitted to the partnership in exchange for the creditor’s contribution to the partnership of part or all of the debt owed to it.

Admitting a new partner where the Troubled Loan is nonrecourse debt.5 As discussed above, if the third party is admitted directly into the partnership, the partnership agreement will be amended and the existing partners’ percentage interests in the income and loss are reduced. In connection with such admission, it must be determined whether the existing capital accounts and the book values of the partnership’s assets are to be adjusted (i.e., booked-up or booked-down) under Reg. §1.704-1(b)(2)(iv)(f). Such adjustments may result in the partners recognizing income or gain, as illustrated below.

Impact on minimum gain shares and minimum gain chargeback. If the partnership has minimum gain6 immediately prior to the admission of the new partner and the Troubled Loan remains constant, and the partnership’s assets are revalued, the adjusted book bases of the assets will be at least equal to the outstanding balance of the nonrecourse debt, thereby reducing the partnership’s minimum gain to zero. At the same time, the existing partners’ capital accounts are increased (presumably to zero) if the value of the partnership property is equal to the nonrecourse debt. As a result, minimum gain chargeback is avoided.7

Effect of the admission on basis. Under Reg. §1.752-3(a), the admission of the new partner and the adjustment of the book bases of the partnership’s assets results in a shift of a portion of the partnership’s nonrecourse debt from the existing partners to the new partner. The amount shifted depends upon the profit percentage of the new partner and the partnership’s book basis in its assets immediately prior to the admission. In most situations, the amount of liabilities shifted to the new partner will equal the new partner’s profit percentage multiplied by the old book basis. The balance of the partnership debt will be allocated solely to the existing partners as their Section 704(c) minimum gain amounts.

While this shift results in a deemed distribution of cash to the existing partners under Sections 752(b) and 733(1), the amount deemed distributed should never exceed the basis of an existing partner in his partnership interest. As a result, the deemed distribution should not result in gain under Section 731(a)(1), if the Troubled Loan remains unchanged following the admission of the new partner. However, if the new partner contributes cash which is used to repay part or all of the Troubled Loan, the existing partners may be deemed to receive taxable distributions under Section 731(a)(1).8

If the partnership has a Section 754 election in effect, the partnership will be entitled to increase its basis in its property under Section 734(b) (subject to Section 755 and the regulations promulgated thereunder). If the election is made, the existing partners should be permitted to correspondingly increase their capital accounts under Reg. §1.704-1(b)(2)(iv)(m)(4). As the partnership claims depreciation deductions with respect to its booked-up assets, the partnership will have increases in its Section 704(b) minimum gain (which will be shared by the partners in accordance with the new profit percentages), and decreases in its Section 704(c) minimum gain. This results in a further shift in liabilities from the existing partners to the new partner, with the existing partners having deemed distributions under Sections 752(b) and 733(1) as the shift occurs. Eventually, the existing partners may receive deemed distributions in excess of their bases, and recognize income under Section 731(a)(1).9

Book adjustments not made. If the partners elect not to revalue the partnership’s assets in connection with the admission of the new partner and the Troubled Loan is not reduced, the partnership’s historic amount of minimum gain and the existing partners’ shares of such gain is retained. As the existing partners retain their historic shares of Section 704(b) minimum gain, the existing partners retain sufficient shares of partnership debt to avoid gain recognition under Section 731(a)(1). So long as a partner’s Section 704(b) minimum gain amount under Reg. §1.752-3(a)(1) is equal to the deficit balance in his capital account, deemed distributions of cash to such partner under Section 752(b) will never result in any taxable gain to such partner under Section 731(a)(1).

In addition, because Section 704(c) minimum gain amounts are not created, there will be no shift of basis over time from the existing partners to the new partners. Not making the revaluation will benefit the existing partners. By not booking-up the assets, Section 704(c) will not be applicable to the partnership and, as a result, the amount of taxable income (or loss) allocated to the new partner may be greater (less) than the amount of taxable income (loss) that would have been allocated to such partner had the partnership’s assets been revalued.10

Peter M. Fass is a partner at Proskauer Rose.


1. Code Section 752(b).

2. Code Section 731(a)(1).

3. See, generally, Reg. §§1.752-1-3.

4. 1984-2 C.B. 119.

5. See, Frankel, Lipton & Miller, "Real Estate Workouts—A Step by Step Analysis" (Practising Law Institute, 2008 Tax Planning for Domestic & Foreign Partnership LLCs, Joint Ventures & Other Strategic Alliances, Volume Six) at 483-485 (hereinafter "Frankel Article").

6. Minimum gain arises when, to the extent that a non-recourse liability exceeds the adjusted basis of the property it encumbers, a disposition of such property will generate gain at least equal to that excess. See, Reg. §§1.704-2(b)(1) and (d)(1).

7. See, Reg. §§1.704-2(d)(4) and 1.704-2(g)(2). Frankel Article at 484.

8. Frankel Article at 484.

9. Frankel Article at 484.

10. Frankel Article at 484.