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review of basis rules

Technical topics regarding tax preparation.
#1
JAD  
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New client, prior CPA did not maintain basis calculations, and now everything is a mess. And I realized that I need a review of how these rules work.

Let's say

2,000 beginning basis
1,000 income
5,000 deductions
4,000 distributions

704(d) basis

2,000 beginning basis
(4,000) distributions
1,000 income
(1,000)
1,000 731(a) gain recognition
0 ending 704(d) basis

465 basis
2,000 beginning basis
(4,000) distributions
(2,000) because at-risk basis can go negative due to distributions

On the return, we have $1,000 of income and the deduction is a $5,000 basis carryover

Correct so far?

Does the 731(a) gain impact the at-risk basis calculation?

What about the potential recapture of negative at-risk $2,000. If the taxpayer claimed losses in the at-risk calculation of at least $2,000 in prior years, then we have recapture income. Does that impact both the 704(b) and 465 calculations? If so, that would eliminate the 731(a) gain.

The Lacerte help screen says that the program treats this recapture as nonpassive income. If the entity is passive, why wouldn't the recapture income also be passive?

Thanks for any help.
 

#2
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To answer your first question, I would think that the 731(a) gain increases the at-risk basis. Distributions in excess of basis are considered a sale of stock, and gain on sale of stock does increase at-risk basis. Someone else will have to chime in on your other question.
 

#3
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Distributions in excess of basis are considered a sale of stock, and gain on sale of stock does increase at-risk basis.

Agreed.

1.465-22(c)(1) states:

Income. A taxpayer's amount at risk in an activity shall be increased by an amount equal to the excess of the taxpayer's share of all items of income received or accrued from the activity during the taxable year over the taxpayer's share of allowable deductions which are allocable to the activity for the taxable year. A taxpayer's amount at risk in an activity shall also be increased by the taxpayer's share of tax-exempt receipts of the activity.

And 1.465-12 states:

In general. Income received or accrued from an activity includes gain recognized upon the disposition of the activity or an interest in the activity in accordance with §1.465-66.

In JAD’s example, if there is nothing funky going on, like NR debt, we shouldn’t have any at-risk issues.

If we pretend the $2k opening basis is a cash capital contribution, for example, basis would be as JAD has it…$2k + $1k - $4k = -$1k…plus $1k gain recognized = $0 ending basis.

His ending at-risk amount would be the same as his ending basis. Note that at this point, we have no lifetime losses hitting the taxpayer’s 1040.

What about the potential recapture of negative at-risk $2,000.

Your negative $2k isn’t right. $1k of income hit the guy’s 1040, which you’re ignoring. $1k of gain for distribution in excess of basis also hit the guy’s 1040. That makes your negative $2k a $0k, same as ending basis.

If the taxpayer claimed losses in the at-risk calculation of at least $2,000 in prior years, then we have recapture income.

Assuming this really was an issue, you’d have to define “losses.” You go to Sec 465(d) for that definition, where you’ll see it says:

(d)Definition of loss
For purposes of this section, the term “loss” means the excess of the deductions allowable under this chapter for the taxable year (determined without regard to the first sentence of subsection (a)) and allocable to an activity to which this section applies over the income received or accrued by the taxpayerduring the taxable year from such activity (determined without regard to subsection (e)(1)(A)).


So…it is a “net” concept. But it does say, “for the taxable” year, implying that we end up with one number for each year…a net positive or a net negative. So, it’s possible we have a lifetime net of $0, for example, comprised of positives for some years and negatives for other years. However, when you go to Sec 465(e), which deals with recapture of “losses,” it says:

(2)Limitation The excess referred to in paragraph (1) shall not exceed—
(A) the aggregate amount of the reductions required by subsection (b)(5) with respect to the activity by reason of losses for all prior taxable years beginning after December 31, 1978, reduced by
(B) the amounts previously included in gross income with respect to such activity under this subsection.

It says, “for all prior taxable years” and “previously” included. This is saying that we look at things on a lifetime basis. In other words, let’s say your $2k opening basis/at-risk was comprised of the following: A $2k cash capital contribution in Year1, a $2k loss in Year1 and a $2k profit in Year2. Is it possible that any part of this [namely the $2k loss claimed in Year1 – because it fits into the definition of a loss under 465(d)] might be subject to at-risk recapture? I say…no way. On a lifetime net basis, the taxpayer hasn’t deducted any losses. One takeaway here is that you kind of have to track things on a lifetime basis, more so with partnerships. That is, the “tax basis capital account” component of basis really needs to be broken out between P&L items and non-P&L items. I use three columns – (1) capital contributions (2) distributions and (3) P&L. Only by doing so do you really know how much of the “tax basis capital account” portion of basis is comprised of lifetime profits/losses. And you need to know that to apply the at-risk rules.

If the entity is passive, why wouldn't the recapture income also be passive?

There’s no guidance on this issue.
 

#4
JAD  
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Thank you both. I printed out your responses and am looking closely at them and my Excel schedule.

Jeff, you said

If we pretend the $2k opening basis is a cash capital contribution, for example, basis would be as JAD has it…$2k + $1k - $4k = -$1k…plus $1k gain recognized = $0 ending basis.

His ending at-risk amount would be the same as his ending basis. Note that at this point, we have no lifetime losses hitting the taxpayer’s 1040.
What about the potential recapture of negative at-risk $2,000.

Your negative $2k isn’t right. $1k of income hit the guy’s 1040, which you’re ignoring. $1k of gain for distribution in excess of basis also hit the guy’s 1040. That makes your negative $2k a $0k, same as ending basis.


Ok, I think I see. I was thinking that the $1,000 of income (not 731(a) gain) was offset by $1,000 of deductions because 465 allows the deduction of expenses up to the amount of income, but that assumes that the deductions were not first limited by 704(d). In other words, 704(d) comes first, and the deductions are limited there, so they are not even considered in the 465 calculation. Right?

The return shows $1,000 of income, $1,000 of 731(a) gain, I have a $5,000 basis carryover, and as you said, both 704(d) basis and at-risk basis = 0. Right?

Recapture income - I understand your points why this example doesn't totally make sense, but let's just keep it simple for now. If we had $2,000 of recapture income, that would increase 465 basis. Does it increase 704(d) basis? On the one hand, I think it should...but then that would eliminate the 731(a) gain and cause allowable deductions. We would have a circular calculation.
 

#5
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Let’s say JAD is a partner and guaranteed $2k worth of debt and had a $2k ordinary loss pass thru from the partnership in Year1.

The deduction is allowed, ending basis is $0 and ending at-risk is $0.

Let’s say Year2 involves break-even operations, no change in the amount of the debt, but it converts to non-recourse. Basis is still zero. However, at-risk drops to negative $2k, which we recapture into income in Year2. Thus, at the end of Year2, ending at-risk is also $0.

On a lifetime basis, we’ve recognized $0 net income [$2k loss reversed with $2k of recapture income].

Now, let’s say in Year3 an investor injects capital and the loan is paid off.

Basis goes from $0 to negative $2k, because we pull the debt from our basis. We recognize 731(a) gain of $2k. Our basis goes up from negative $2k to $0. From an at-risk standpoint, our at-risk also goes up by $2k. To make it all work out, the $2k recapture in Year2 is treated as an allowable deduction in Year3, for at-risk purposes, to the extent we have income in Year3 “from the activity.” Thus, the amount we recaptured into income in Year2 (the $2k) becomes an at-risk deduction in Year3.

So, here’s what happened on a lifetime basis:

Year1 loss allowed = ($2k).
Year2 income (at-risk recapture) = +$2k.
Year3 income (deemed distrib in excess of basis) = + $2k.
Year 3 loss allowed (reversal of at-risk recapture income) = ($2k).

It all adds up to $0, which makes sense, since JAD invested nothing into the partnership.

See Sec 465(e)(1)(B):

(B) an amount equal to the amount so included in gross income shall be treated as a deduction allocable to such activity for the first succeeding taxable year.

So, this all works out by not increasing 704(d) basis for the at-risk recapture income. Instead, the Code makes us whole by giving us a future at-risk deduction instead of a basis increase.
 

#6
JAD  
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Jeff, thanks for this excellent example, and apologies for returning to this discussion so late. Inlaws visited, I went on vacation, and then returned to a firestorm of client issues.

I just finished updating my formerly rudimentary Excel schedule to track all of this. I now have the following columns:

1. Capital account, because I like tying to the K-1 if it is prepared on a tax basis
2. 704(d)
3. 465
4. Cumulative income/deduction, so I know the potential 465(e) income recapture
5. Cumulative 465(e), so that I know potential reversal of income recapture
6. Nonrecourse debt
7. Recourse debt/QNRD

Most irritatingly, I should maintain Columns 2 - 5 for federal AMT, California, and California AMT. That makes a many column worksheet. Are you aware of a way to streamline this when there are basis issues?
 


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