When a Real Estate Partnership Interest becomes Worthless
By Professor Joel Rosenfeld, CPA
JIR Consulting, LLC and Adjunct Assistant Professor, NYU Schack Real Estate Institute, Graduate School
October 11, 2013
A Worthless Partnership Interest
Many investors in real estate partnerships maybe totally unaware of a favorable tax benefit when their partnership interest becomes worthless. The partnership interest may become worthless as a result of many factors, such as a significant devaluation of the property, vacancies, mismanagement and overall declining economic conditions. Very often the partnership will struggle along in hope of a recovery of economic conditions or a mitigation of the factors that directly caused the property to become financially distressed. While the Managing Partners attempt to keep the partnership "afloat," the partnership interest may in fact be worthless.
Interestingly, a taxpayer's determination of worthlessness is a subjective determination by a taxpayer predicated on the taxpayer's own specific personal set of economic factors. The subjective decision of worthlessness must have some merit that the asset is "materially valueless." The taxpayer is entitled to the same discretion in determining the real property is essentially without value as the taxpayer would to abandon their partnership interest.
The taxpayer has no requirement to pro-actively prove that the asset has significantly diminished in value, but may look to the events that render the asset valueless. For example, the partnership's default of the mortgage and the inability to restructure the debt may render the partnership without value based on an impending foreclosure. Environmental conditions may have a direct effect on the real property and may cause the asset to be worthless.
If the partnership abandons the real property, the event is clearly defined and if the taxpayer does not anticipate an economic benefit and has no hope to recover his or her investment, it is clear that the taxpayer's partnership interest is worthless. However, is it necessary for the partnership to abandon the real property? Does the taxpayer have to dispose of his partnership interest in order to claim a tax deduction?
In IRS Rev. Ruling 93-80, the IRS indicates that a loss from a worthless partnership interest is an ordinary loss deduction (not capital loss) so long as there is no actual deemed distribution to the partner, or the transaction is not otherwise in substance a sale or exchange of the partner's interest. The argument for an ordinary loss deduction where there are no partnership liabilities may be under a claim of worthless because typically in a worthless situation there is no actual or deemed disposition of the partnership interest. A partner that declares his partnership interest to be worthless does not generally relinquish his partnership interest, and correspondingly does not decrease his share of partnership liabilities and does not have a deemed distribution under IRC Section 752(b). Although a partner may declare the partnership interest as worthless and the partner will continue to retain his or her interest in the partnership.
A determination of worthless requires both a subjective determination as to when the taxpayer deems the partnership interest to be worthless and an objective determination as to whether the partnership interest is without value at that time. Under the subjective test, the taxpayer's intent, whereby a claim is made that the partnership interest is worthless and is evidenced by his or her actions and circumstances. For example, if the partner cannot fund the losses and does not reasonably expect that the investment will provide a return on the investment, then the partner, based on his or her set of personal factors, may declare the partnership interest as worthless and may take an ordinary loss deduction.
Worthlessness is not just based on the partner's opinion. A requirement of an objective determination of value looking at the economic conditions of the partnership at that time is necessary. For example, if the cash flow has dried up and the partner determines that he or she will not contribute any additional funds to the partnership, and the liquidation of assets will not create enough funds to retire the debt. In addition, it is highly unlikely that the partnership will have the capability to make distributions to the partners, and then the partnership interest could objectively be declared worthless at the time of determination.
If the taxpayer passes both the subjective and objective tests for worthlessness, then the worthless partnership interest will generate an ordinary loss deduction under IRC Section 165(a) even though the taxpayer continues to be a partner in the partnership. A partner can only take an ordinary deduction to the extent of their positive capital account at the date of determination, which effectively is the invested capital.
(Note: The capital account can be different from the tax basis of the partnership. Inquire about whether there are any differences.)
Abandonment of a Partnership Interest
In many instances partners may conclude that their partnership interest is worthless and decide to abandon their partnership interest. There exists a major difference between abandonment and a claim of a worthless partnership interest. To claim an ordinary loss deduction on the abandonment of the partnership interest there must be an actual abandonment of the partnership interest rather than a "sale or exchange" of a capital asset (the partnership interest).
Abandonment of an asset occurs when a taxpayer abandons property and receives nothing in return. If the taxpayer receives a deemed consideration, the loss is a capital loss from a deemed sale or exchange of the partnership interest. An understanding of the facts and circumstances at the time of the abandonment is crucial in determining whether the actions of the partner constitute abandonment or sale of the partnership interest. Both the IRS and the Tax Courts have ruled that there must be some overt action on part of the partner to communicate his intent to surrender the partnership interest to the partnership, general partner and third parties.
The amount of an abandonment loss is calculated as the total of the abandoning partner's unrecovered basis. The abandonment will result in a gain if at the time of the abandonment the partner is relieved of liabilities in excess of his or her basis in the partnership interest.
Based on facts and circumstances, taxpayers may have an ordinary loss deduction or a capital gain or loss. Generally, a loss from a worthless partnership interest is an ordinary loss due to the absence of a sale or exchange. Furthermore, a claim of a worthless partnership interest is not an abandonment of the partnership interest; the partner will continue to have ownership in the partnership. On the other hand, a partner that abandons their partnership interest will have no further interest in the subject partnership. In addition, the partnership agreement will have to be amended in order to reflect the abandonment of the partnership interest. Partners that desire to walk away from their partnership interest should pay close attention to the partnership liabilities, which relief of liabilities will be characterized as a sale or exchange and will create an entirely different tax implication.
(Note: Taxpayers should always seek advice from a professional tax advisor about their individual situation.)