Debt Financed Distribution, Subsequent Sale

Pship has partners A, B and C. The partnership holds rental real estate.

During the tax year, the partnership does a cash-out refinancing on one of the properties. It then distributes those proceed to A, B and C. This is a debt financed distribution.

Later in the tax year, A sells his interest to D and E, and exits the partnership.

What happens to the portion of mortgage interest that's apportioned to A's debt financed distribution after he exists the partnership? Does it become entity level interest? Or do D and E step into his shoes?

The latter does not make much sense to me, as D and E never received cash.

The departed partner ends up (effectively) paying tax on the debt proceeds distributed to him when he exits. This is the "loophole" the DFD rules are looking to "close". Once tax is paid on those proceeds, there's nothing left to account for regarding DFDs.
D&E do not step into his shoes as you expect.
The interest expense is just entity debt at that point.

Thanks CaptCook. I was thinking through it while eating lunch and came to a similar conclusion that made me comfortable. Partner disposed of their interest in a taxable transaction. The DFD was essentially an advance of the partnership interest sale due to the economics of how that interest is valued.

Capt,

What does it mean that the interest expense is entity debt at that point?

Capt can clarify, but I'm pretty sure he means the associated interest is treated just like interest from any other entity-level debt. As opposed to a DFD, where the associated interest is separately stated and sourced to the shareholder so they may determine tax treatment.

Economically, the debt supporting the previous DFD to the former partner is now debt used to buyout the former partner, which has no significance from a deductibility standpoint over any other debt.

Does it become entity level interest?

See the Lipnick case, which involved a gift of an interest. I think one question here is how to report the interest expense to the new partner. One option is to separately state it and then that partner makes his own decision. But query here if the DFD rules have been foreclosed upon acquisition. It’s kind of a weird animal…where if we don’t separately state it, we are effectively stating that the DFD rules don’t apply. In addition, we are making a decision as the preparer. That might not be wrong, however.

The DFD was essentially an advance of the partnership interest sale due to the economics of how that interest is valued.

I get it, but I don’t think it’s a holistic analysis, per se. You do touch on how the interest is valued, which would of course impact the purchaser. And when viewed from the purchaser’s standpoint, that debt that is now allocated to him was, effectively, factored into the cost of his acqusition. And what did he acquire? Partnership assets, if we look within. So, if we were to trace, we’d trace to the nature of the partnership’s assets. If they’re ordinary assets, the incoming partner has an ordinary deduction. How that gets presented, I leave it up to you. What you really have here is a new partner taking on debt to make an acquisition of a partnership interest. We all know the rules there: Trace to the assets of the partnership and deduct the interest accordingly. The weird thing about this situation is that the debt is internal, not external. While that is true with any other partnership that has entity level debt, what we have here is a single debt whose treatment is not uniform for all partners. In short, I think the normal tracing rules of 89-35 apply, but the reporting of the interest expense and who makes decisions surrounding it is the odd-ball.

I would favor leaving the interest as DFD for the purchasing partner and then the purchaser deducting it as acquisition interest, which I think is maybe what Capt was getting at in #6.

If the DFD status of the interest goes poof and it becomes entity interest, that interest expense would be split via PIP, which doesn't feel right considering the other members continue to receive special allocations of their interest expense.

Jeff/PD, you both bring up an interesting point regarding continuing to trace it to the purchaser(s) and have them deduct it as acquisition interest.
This was not my thought above, but I don't disagree that it has merit.
My thought was that the entity "purchased" some of A's interest by making a DFD prior to his exit. When A sold to D&E, he "matched" the other side of that income recognition event and now the entity can deduct the interest it incurs/pays on the cash paid in that "purchase". I would expect cash flow otherwise due to all partners to be used to satisfy this obligation and, thus, they would all share in the expense.
It is an oddball, but I'd be curious for your thoughts. What are the holes in my thought above?
If presented this situation in the future, do we have options to clarify this in the buyout negotiations or is there only one approach we must follow?

My thought was that the entity "purchased" some of A's interest by making a DFD prior to his exit.

The entity purchased some of A's interest but also some of B's and C's interest in the same transaction.

When the DFD was accomplished, the FMV of the partnership, as well as the inside tax basis of assets were reduced due to the distribution. However, the 704(c) difference in those assets did not change. I know I'm merging concepts but hang in there.

When D and E buy in, their step ups will be based on the difference between the price they paid and inside tax basis. But under your method, they no longer receive the interest allocation the seller enjoyed, so will they receive an additional 743 step up for the lost interest allocations? If no, now D and E's 704(c) difference will vary in comparison to A and B's who continue to receive DFD allocations.

In OP's case, the transaction was structured as a partnership interest transfer, so I would leave the DFD alone and continue to allocate to the purchasing members. Were the transaction a redemption, my answer would flip I think.