As discussed on this blog previously, distributions of partnership assets in liquidation prior to exchanges by partners are commonly called “drop-and-swap” transactions. The partnership can distribute the assets to the partners astenants-in-common in exchange for each partner’s interest, subject to a tenancy in common agreement. However, the distribution of property subject to debt out of the partnership can easily be treated as a taxable transaction despite Section 731(a).

The significant issue is that upon the distribution in complete liquidation, the adjusted tax basis for the distributed property may be less (and sometimes much less) than the tax basis in the hands of the partnership.  Therefore, the distribution causes the taxable gain on a subsequent sale to be greater.  This is known as the disappearing basis rule.

Furthermore, if the partner receives encumbered property in a liquidating distribution, the partner must determine whether he or she has a net increase or decrease in liabilities.  If the partner is subject to a decrease in liabilities, the decrease will be treated as a distribution of cash.  If the “deemed distribution” is greater than the partner’s outside basis, the partner must recognize gain in an amount by which the deemed distribution exceeds his or her outside basis.

Finally, liquidation triggers the restoration of a negative capital account.  Upon a liquidating distribution, a partner with a negative capital account must restore the capital account deficit, with certain exceptions provided in the regulations, to be paid to creditors of the partnership or distributed to partners with positive capital accounts.  Treas. Reg. Section  1.704-1(b)(2)(ii)(b)(3).  Note that the capital account does not include the amount of debt incurred by the partnership.  Thus, it is likely that in a typical real estate venture the negative capital account will be significant.

For example:

Partner A and Partner B each own 50% of Partnership AB. Partners A and B each contributed $100,000 to Partnership AB to purchase two parcels of property. Partnership AB owns two parcels of property: Parcel 1 is worth $500,000 and is encumbered by $400,000 of debt;  Parcel 2 is worth $100,000 and has no debt.

If Partner A receives Parcel 2 in complete liquidation of his interest in the partnership, the release of his 50% share of the $400,000 debt is treated as a distribution of cash in the amount of $200,000 to himself. Likewise, Partner B will receive Parcel 1 and will be treated as having contributed $200,000 of cash for the assumption of the debt for Parcel 1.

The $200,000 deemed cash distribution reduces Partner A’s initial investment in the partnership (outside tax basis) of $100,000 to zero and the excess $100,000 is treated as gain from the sale or exchange of Partner A‘s interest in Partnership AB. IRC section 731(a)(2). Furthermore, the property received has a zero tax basis.

For more information on 1031 exchanges, contact the tax attorneys at All States 1031 Exchange Facilitator at 877-395-1031.