This column continues the review of the considerations1 for the individual partners and LLC members owning an interest in a partnership or limited liability company (LLC) owning real property that secures a loan (a troubled investment) which loan defaults or is restructured, with a discussion of holding or selling the interest.

Retaining Interest

There may be a benefit from holding onto an interest that produces taxable income without cash because the phantom income generated will generally constitute passive activity income under Section 469. Consequently, such passive activity income can be sheltered by the passive activity losses of other more recently acquired passive investment. These passive activity losses which would otherwise be disallowed can now provide a current tax benefit to the extent of the passive activity income being generated by the troubled investment.

If the troubled investment is a publicly traded partnership (PTP), however, its income is treated as portfolio rather than passive income.2 A PTP generally is a partnership whose interests are traded on an established securities market or are readily tradable in a secondary market (or the substantial equivalent thereof). As a result, an investor will not be able to offset passive activity losses from other investments with the income generated by the PTP and holding one’s interest in such an investment is not a viable alternative.

Taxable Sale

The possibility of selling a partnership or LLC interest in a troubled investment may be quite remote unless the potential buyer is very naive. However, if a potential buyer has investments that are generating passive activity losses which are being disallowed under Section 469, the buyer may have a genuine desire to purchase an investment that is "throwing off" passive income. The various tax consequences associated with selling an interest are discussed below.

General. The sale of an interest may result in the recognition of a taxable gain by the selling partner equal to the difference between the amount realized by the partner and his adjusted basis in his interest. The amount realized includes any cash and the fair market value (FMV) of any property received in exchange for the interest plus the share of the partnership or LLC liabilities relieved of as a result of the sale.

Due to the fact that many tax-advantaged investments are structured to report large "paper losses" in the early years that are passed through to the partners, reducing the partners’ bases in their interests, it is probable that a partner’s share of liabilities will exceed his adjusted basis and that he will recognize a gain on the sale of his interest.

In general, a partner will recognize a long-term capital gain on the sale of his interest if he has held the interest for more than one year. Capital gain characterization is important because (i) the maximum 20 percent rate on net capital gains is less than the 39.6 percent maximum individual tax rate, and (ii) the capital gain can be offset if an individual has other capital losses in the year of sale or capital loss carryovers.

Section 751 Recapture. The capital gain from the sale of the interest will be recharacterized as ordinary income to the extent of the share of the partnership’s or LLC’s Section 751 hot assets.3 Section 751 hot assets include unrealized receivables, market discount bonds, substantially appreciated inventory, and certain recapture items (e.g., Section 1245 and Section 1250 depreciation recapture).

As an administrative matter, the selling partner must provide the partnership with certain information regarding himself and the purchaser within 30 days of the sale if the partnership has any Section 751 hot assets.4 Failure by the transferor partner to provide this information to the partnership could result in the IRS asserting a $50 penalty against him.5

Installment Sales. A partner may be able to defer gain recognition as a result of the sale of his interest through the use of the installment method under Section 453 if at least one payment for his interest is to be received after the close of the taxable year in which the sale occurs. Under the installment method, a partner would recognize income on the sale of his interest equal to the payments received in a taxable year attributable to the sale multiplied by his gross profit ratio (i.e., the ratio of the gross profit from the sale to the total contract price of his interest).

A partner is, however, required to recognize any "recapture income" in the year of the sale of his interest. "Recapture income" is defined as ordinary income under the depreciation recapture rules of Section 1245 or 1250 (or so much of Section 751 that relates to Section 1245 or 1250). Thus, a selling partner may be required to recognize gain in excess of the cash received in the year of sale.

Cancellation of Indebtedness Income. If individual liability (for example, to the partnership or LLC) will be extinguished in the sale or exchange, income from the cancellation of indebtedness may be recognized by the selling partner under Section 61(a)(12). Accordingly, the current tax cost of the cancellation of indebtedness income (COD Income) should be compared with the present value of the obligation to pay the debt when it becomes due, in order to determine if relief from the obligation is worth the current tax cost. If the individual partner is bankrupt or insolvent, he may not be required to recognize all or a portion of this COD Income due to the exclusion provided in Section 108. However, certain of his other tax attributes will be reduced unless he makes an election to decrease the basis of any other depreciable property he owns first.6

Like-Kind Exchange Treatment Not Available. The like-kind exchange rules under Section 1031 do not consider interests in different partnerships or LLCs to constitute like-kind property. Accordingly, a partner cannot use the like-kind exchange rules to effectuate a tax-deferred exchange of an interest in one partnership for an interest in any other partnership or LLC.7 The regulations specifically provide that Section 1031(a)(1) does not apply to any exchange of interests in a partnership regardless of whether the interests exchanged are general or limited partnership interests in the same partnership or in different partnerships.

However, if a partnership makes a Section 761(a) election not to be subject to the Subchapter K rules, an interest therein will be treated as an interest in each of the assets of the partnership. However, an exchange of an interest in such a partnership will not qualify for Section 1031 non-recognition treatment to the extent any asset is described in Section 1031(a)(2). Included in those assets are inventory, stock, bonds or notes, other securities or evidence of indebtedness, interests in a partnership, trust certificate or choses in action.

Peter M. Fass is a partner at Proskauer Rose.

Endnotes:

1. See, NYLJ, vol. 249, no. 63 (April 3, 2013).

2. I.R.C. §469(k)(1).

3. I.R.C. §741; Reg. §1.741-1(a).

4. I.R.C. §6050K(c).

5. I.R.C. §6723.

6. I.R.C. §§108(b) and 1017.

7. I.R.C. §1031 (a)(2)(D); Reg. §1.1031(a)-1(a)(1).