Debt Basis

Does a partner in partnership have to deduct losses against debt basis if they don't want to? The goal in this fact pattern is for it to be a long-term investment. However, for this client that invested into a commercial piece of real estate, in the first year alone the loss on the K-1 exceeded the 50K of capital he invested(probably cost seg depreciation). He guaranteed the debt, so he is at risk and can take the additional 10K in losses against debt basis. My concern is if he ever wants to sell his stake or if the holding never becomes profitable and he has to restore whatever debt basis he deducted.

If possible, I would like to present the client with the decision to or not to, but I have a feeling they have no choice? This year is not so bad since he is mostly deducting the loss relating to the 50K capital he invested. In future years I'm not sure how great of a choice it is to just be deducting straight debt basis.

Thanks!

Whether to deduct losses or not is not an election you can make.

is the partner deducting / getting a benefit from the losses?

The resulting economic loss is one thing, and the ability to deduct it is another.

He has some basis to support his loss ($50K), and he has at-risk basis (via his loan guarantee) to support the rest. The next hurdle to deducting the loss would be the passive activity loss rules.

Since rental activities are passive per se, unless he meets the active participation rules or is a materially participating real estate professional, his loss would generally be suspended due to the passive loss limitation rules. So let's presume he has a suspended passive loss after this.

Selling his interest in the partnership would be a disposition of his entire interest in a passive activity and that would free up his suspended passive loss. A portion of any gain he picks up from selling his interest would be sheltered by the suspended passive losses. Any unsheltered gain would be actual economic gain from the sale.

If the project failed and he had to make good on his guarantee, he would merely be "paying for" the losses previously allocated to him, which that debt originally supported. Restoring any debt would be his economic outlay in paying for those prior allocated losses.

On the other hand, If the project becomes profitable, his allocation of income would be offset by those suspended passive losses to a point.

He could run into an issue if he accumulates passive losses and is relieved of his obligation to guarantee the debt. He would have negative at-risk basis and would have to recognize income to the extent of losses taken that were supported by that guaranteed debt. But again, he would have suspended passive losses to cover that.

Would he be able to deduct the 50K in losses relating to the 50K he contributed? I guess I thought you were allowed to take a passive loss if you had basis, but its been a while since I've seen this type of thing. This is a real estate activity, so we only need active participation, not material participation

So you're only able to deduct passive losses against passive income and you have to have basis to deduct that passive loss. So I'm thinking that the 50K is going to have to be carried forward... ugh... I hate these types of things, it makes no sense to me that he cannot deduct his 50K

There are three "doors" to consider for losses:
1) Does the taxpayer have economic basis (investment + allocated debt)?
2) Does that taxpayer have at-risk basis (investment + recourse debt)?
3) Is the loss passive with no passive income to offset it?

The consideration must be in this order to ensure the loss is suspended at the proper level, if it is.

He defintely has the eoncomic and at risk basis but he owns less than 10% of the entity (his 50K bought him 2.5% of the investment)...

So we shall have a suspended loss!

Rather than start a new thread I would like to expand on this one if I may.

Similar situation to the OP except this is a partnership that is a trade or business with operating losses. The partnership interest is held by another partnership.

Through the benefit of debt basis the partners have been taking substantial losses over a period of 15 years and have significant negative capital accounts. A K-1 marked final was received this year that shows a small gain on disposition of the business. Although details are sketchy on how the transaction was structured there was no capital account restoration when the partnership closed.

Since the partner received the benefit of the losses without any outlay of funds, wouldn't the taxpayer be required to recognize income to the extent of losses taken?

I have a lot of unraveling to do in order to get to a true basis number (crappy record keeping by client & prior preparer) but it seems like ultimately there is going to be some income recognition. Or, am I missing something?

Relieved debt is a deemed distribution at the very least. If this debt wasn't accounted for properly in the 1065 as additional proceeds in the sales transaction, then you have distributions in XS of basis to show for the partner.

Relieved debt is a deemed distribution at the very least. If this debt wasn't accounted for properly in the 1065 as additional proceeds in the sales transaction, then you have distributions in XS of basis to show for the partner.

There seems to be a lot of questions regarding this whole deal. The decrease in nonrecourse debt is $3 million which is where the questions start. I am having a hard time conceptually with how this deal was structured, Hopefully the client or more likely the partnership tax preparer can provide clarity.

There seems to be a lot of questions regarding this whole deal.

Agreed. Easy answer is that debt allocation is part of outside basis. When debt goes away, basis goes negative, so we have gain recognition to bring it back up to $0. (In your case, you would have had an at-risk problem, so hopefully you have a bunch of suspended losses to offset whatever gain we might end up with).

But what you’re wondering about (the conceptual comment), and me, is the inside/outside symmetry. Pretend $3m borrowed inside. It’s all spent. Inside basis is $0. If we sell, we should have a big gain coming through. And we wonder about debt payoff, if it was all paid off or not. Your K1 “seemingly” indicates that it was all paid off. But if we don’t sell for enough to pay off the debt, then there’s still some kind of income we have to recognized on the inside…add’l sales proceeds for debt relief or COD income. But we’re not seeing any of that on the K1.

One possibility is that the debt didn’t get paid off, per se. Rather, some partner personally guaranteed whatever was left on it. That is, it converted from NR to R. Or, some partner made a capital contribution to pay off the debt. Those are the only valid things that come to mind. What else comes to mind is a bad accountant who prepared the 1065 all wrong for a number of years, including the characterization of the debt and the allocation of losses.

There seems to be a lot of questions regarding this whole deal.

Agreed. Easy answer is that debt allocation is part of outside basis. When debt goes away, basis goes negative, so we have gain recognition to bring it back up to $0. (In your case, you would have had an at-risk problem, so hopefully you have a bunch of suspended losses to offset whatever gain we might end up with).

One possibility is that the debt didn’t get paid off, per se. Rather, some partner personally guaranteed whatever was left on it. That is, it converted from NR to R. Or, some partner made a capital contribution to pay off the debt. Those are the only valid things that come to mind. What else comes to mind is a bad accountant who prepared the 1065 all wrong for a number of years, including the characterization of the debt and the allocation of losses.

I'm coming into the situation in the 9th inning and playing catch up. I haven't looked at the 1040's in question but my understanding is there are no suspended losses.

I have started the process of recreating the activity from prior year tax returns and general ledgers as well as calculating basis using the prior year's K-1's. Hopefully that provides some insight although I have already noted material differences between the two.