Partner's Exclusions and Deductions
To determine the allowable amount of any exclusion or deduction subject to a limit, a
partner must combine any separate exclusions or deductions on his or her income tax return
with the distributive share of partnership exclusions or deductions before applying the
limit.
Cancellation of qualified real property business debt.
A partner other than a C corporation can elect to exclude from gross
income the partner's distributive share of income from cancellation of the
partnership's qualified real property business debt. This is a debt (other than a
qualified farm debt) incurred or assumed by the partnership in connection with real
property used in its trade or business and secured by that property. A debt incurred or
assumed after 1992 qualifies only if it was incurred or assumed to acquire, construct,
reconstruct, or substantially improve such property. A debt incurred to refinance a
qualified real property business debt qualifies, but only up to the refinanced debt.
A partner who elects the exclusion must reduce the basis of his or her depreciable real
property by the amount excluded. For this purpose, a partnership interest is treated as
depreciable real property to the extent of the partner's share of the partnership's
depreciable real property. However, a partnership interest cannot be treated as
depreciable real property unless the partnership makes a corresponding reduction in the
basis of its depreciable real property with respect to that partner.
To elect the exclusion, the partner must file Form
982, Reduction of Tax Attributes Due to Discharge of Indebtedness, with
his or her original income tax return. However, if the partner timely filed the return
without making the election, he or she can still make the election by filing an amended
return within six months of the due date of the original return (excluding extensions).
The election must be attached to the amended return with Filed pursuant to section
301.9100-2 written on the election statement. The amended return should be filed at
the same address as the original return.
Exclusion limit. The partner's exclusion cannot be more
than the smaller of the following two amounts.
- The partner's share of the excess (if any) of:
- The outstanding principal of the debt immediately before the cancellation, over
- The fair market value (as of that time) of the property securing the debt, reduced by
the outstanding principal of other qualified real property business debt secured by that
property (as of that time).
- The total adjusted bases of depreciable real property held by the partner immediately
before the cancellation (other than property acquired in contemplation of the
cancellation).
Effect on partner's basis. Because of offsetting
adjustments, the cancellation of a partnership debt does not usually cause a net change in
the basis of a partnership interest. Each partner's basis is:
- Increased by his or her share of the partnership income from the cancellation of debt
(whether or not the partner excludes the income), and
- Reduced by the deemed distribution resulting from the reduction in his or her share of
partnership liabilities.
(See Adjusted Basis under Basis of Partner's Interest, later.) The
basis of a partner's interest will change only if the partner's share of income is
different from the partner's share of debt.
As explained earlier, however, a partner's election to exclude income from the
cancellation of qualified real property business debt may reduce the basis of the
partner's interest to the extent the interest is treated as depreciable real property.
Basis of depreciable real property reduced. If the basis of
depreciable real property is reduced and the property is disposed of, then the following
rules apply for purposes of determining the ordinary income from recapture of depreciation
under section 1250 of the Internal Revenue Code.
- Any such basis reduction is treated as a deduction allowed for depreciation.
- The determination of what would have been the depreciation adjustment under the straight
line method is made as if there had been no such reduction.
Therefore, the basis reduction recaptured as ordinary income is reduced over the time
the partnership continues to hold the property, as the partnership forgoes depreciation
deductions due to the basis reduction.
Section 179 deduction. A
partnership can elect to deduct all or part of the cost of certain assets under section
179 of the Internal Revenue Code. The deduction is passed through to the partners
as a separately stated item.
Limits. The section 179 deduction is subject to certain
limits that apply to the partnership and to each partner. The partnership determines its
section 179 deduction subject to the limits. It then allocates the deduction among its
partners.
Each partner adds the amount allocated from the partnership (shown on Schedule K-1) to
his or her other nonpartnership section 179 costs and then applies the maximum dollar
limit to this total. To determine if a partner has exceeded the $200,000 investment limit,
the partner does not include any of the cost of section 179 property placed in service by
the partnership. After the maximum dollar limit and investment limit are applied, the
remaining cost of the partnership and nonpartnership section 179 property is subject to
the taxable income limit.
Figuring partnership's taxable income. For purposes of the
taxable income limit, taxable income of a partnership is figured by adding together the
net income (or loss) from all trades or businesses actively conducted by the partnership
during the tax year.
Figuring partner's taxable income. For purposes of the
taxable income limit, the taxable income of a partner who is engaged in the active conduct
of one or more of a partnership's trades or businesses includes his or her allocable share
of taxable income derived from the partnership's active conduct of any trade or business.
Basis adjustment. A partner who is allocated section 179
expenses from the partnership must reduce the basis of his or her partnership interest by
the total section 179 expenses allocated, regardless of whether the full amount allocated
can be currently deducted. See Adjusted Basis under Basis of Partner's
Interest, later. If a partner disposes of his or her interest in a partnership, the
partner's basis for determining gain or loss is increased by any outstanding carryover of
disallowed deductions of section 179 expenses allocated from the partnership.
The basis of a partnership's section 179 property must be reduced by the section 179
deduction elected by the partnership. This reduction of basis must be made even if any
partner cannot deduct his or her entire allocable share of the section 179 deduction
because of the limits.
More information. See Publication 946 for more information
on the section 179 deduction.
Amortization deduction for reforestation costs. A partnership can
elect to amortize certain reforestation costs for qualified timber property over an
84-month period. The amortizable costs are passed through to the partners as a separately
stated item.
Annual limit. The election can be made for no more than
$10,000 of qualified costs each tax year. Both the partnership and partner are subject to
this limit. The partnership applies the $10,000 limit in determining the amount of its
amortizable costs and allocates that amount among its partners. The partner adds the
amount allocated from the partnership to his or her qualified costs from other sources and
then applies the $10,000 limit ($5,000 limit, if married filing a separate return).
More information. See chapter 9 of Publication 535 for more
information.
Partnership expenses paid by partner. In general, a partner cannot deduct partnership expenses paid out of personal
funds unless the partnership agreement requires the partner to pay the expenses.
These expenses are usually considered incurred and deductible by the partnership.
If an employee of the partnership performs part of a partner's duties and the
partnership agreement requires the partner to pay the employee out of personal funds, the
partner can deduct the payment as a business expense.
Interest expense for distributed loan. If the partnership distributes borrowed funds to a partner, the partnership
should list the partner's share of interest expense for these funds as Interest
expense allocated to debt-financed distributions under Other deductions on
the partner's Schedule K-1. The partner deducts this interest on his or her tax return
depending on how the partner uses the funds. See chapter 5 in Publication 535 for more
information on the allocation of interest expense related to debt-financed distributions.
Debt-financed acquisitions. The interest expense on loan proceeds
used to purchase an interest in, or make a contribution to, a partnership must be
allocated as explained in chapter 5 of Publication 535.
Partnership Distributions
Partnership distributions include the following.
- A withdrawal by a partner in anticipation of the current year's earnings.
- A distribution of the current year's or prior years' earnings not needed for working
capital.
- A complete or partial liquidation of a partner's interest.
- A distribution to all partners in a complete liquidation of the partnership.
A partnership distribution is not taken into account in determining the partner's
distributive share of partnership income or loss. If any gain or loss from the
distribution is recognized by the partner, it must be reported on his or her return for
the tax year in which the distribution is received. Money or property withdrawn by a
partner in anticipation of the current year's earnings is treated as a distribution
received on the last day of the partnership's tax year.
Effect on partner's basis. A partner's adjusted basis in his or her
partnership interest is decreased (but not below zero) by the money and adjusted basis of
property distributed to the partner. See Adjusted Basis under Basis of
Partner's Interest, later.
Effect on partnership. A partnership generally does not recognize
any gain or loss because of distributions it makes to partners. The partnership may be
able to elect to adjust the basis of its undistributed property, as explained later under Adjusting
the Basis of Partnership Property.
Certain distributions treated as a sale or exchange. When a
partnership distributes the following items, the distribution may be treated as a sale or
exchange of property rather than a distribution.
- Unrealized receivables or substantially appreciated inventory items distributed in
exchange for any part of the partner's interest in other partnership property, including
money.
- Other property (including money) distributed in exchange for any part of a partner's
interest in unrealized receivables or substantially appreciated inventory items.
See Payments for Unrealized Receivables and Inventory Items under Disposition
of Partner's Interest, later.
This treatment does not apply to the following distributions.
- A distribution of property to the partner who contributed the property to the
partnership.
- Payments made to a retiring partner or successor in interest of a deceased partner that
are the partner's distributive share of partnership income or guaranteed payments.
Substantially appreciated inventory items.
Inventory items of the partnership are considered to have appreciated
substantially in value if, at the time of the distribution, their total fair market
value is more than 120% of the partnership's adjusted basis for the property. However, if
a principal purpose for acquiring inventory property is to avoid ordinary income treatment
by reducing the appreciation to less than 120%, that property is excluded.
Partner's Gain or Loss
A partner generally recognizes gain on a partnership distribution only
to the extent any money (and marketable securities treated as money) included in
the distribution exceeds the adjusted basis of the partner's interest in the partnership.
Any gain recognized is generally treated as capital gain from the sale of the partnership
interest on the date of the distribution. If partnership property (other than marketable
securities treated as money) is distributed to a partner, he or she generally does not
recognize any gain until the sale or other disposition of the property.
For exceptions to these rules, see Distribution of partner's debt and Net
precontribution gain, later. Also, see Payments for Unrealized Receivables and
Inventory Items under Disposition of Partner's Interest, later.
Example. The adjusted basis of Jo's partnership interest is
$14,000. She receives a distribution of $8,000 cash and land that has an adjusted basis of
$2,000 and a fair market value of $3,000. Because the cash received does not exceed the
basis of her partnership interest, Jo does not recognize any gain on the distribution. Any
gain on the land will be recognized when she sells or otherwise disposes of it. The
distribution decreases the adjusted basis of Jo's partnership interest to $4,000 [$14,000
- ($8,000 + $2,000)].
Marketable securities treated as money. Generally, a marketable security distributed to a partner is treated as money
in determining whether gain is recognized on the distribution. This treatment,
however, does not generally apply if that partner contributed the security to the
partnership or an investment partnership made the distribution to an eligible partner.
The amount treated as money is the security's fair market value when distributed,
reduced (but not below zero) by the excess (if any) of:
- The partner's distributive share of the gain that would be recognized had the
partnership sold all its marketable securities at their fair market value immediately
before the transaction resulting in the distribution, over
- The partner's distributive share of the gain that would be recognized had the
partnership sold all such securities it still held after the distribution at the fair
market value in (1).
For more information, including the definition of marketable securities, see section
731(c) of the Internal Revenue Code.
Loss on distribution. A partner does not recognize loss on a
partnership distribution unless all the following requirements are met.
- The adjusted basis of the partner's interest in the partnership exceeds the
distribution.
- The partner's entire interest in the partnership is liquidated.
- The distribution is in money, unrealized receivables, or inventory items.
There are exceptions to these general rules. See the following discussions. Also, see Liquidation
at Partner's Retirement or Death under Disposition of Partner's Interest, later.
Distribution of partner's debt. If
a partnership acquires a partner's debt and extinguishes the debt by distributing it to
the partner, the partner will recognize capital gain or loss to the extent the fair
market value of the debt differs from the basis of the debt (determined under the rules
discussed in Partner's Basis for Distributed Property, later).
The partner is treated as having satisfied the debt for its fair market value. If the
issue price (adjusted for any premium or discount) of the debt exceeds its fair market
value when distributed, the partner may have to include the excess amount in income as
canceled debt.
Similarly, a deduction may be available to a corporate partner if the fair market value
of the debt at the time of distribution exceeds its adjusted issue price.
Net precontribution gain. A
partner generally must recognize gain on the distribution of property (other than money)
if the partner contributed appreciated property to the partnership during the
7-year period before the distribution.
A 5-year
period applies to property contributed before June 9, 1997, or under a written binding
contract:
- That was in effect on June 8, 1997, and at all times thereafter before the contribution,
and
- That provides for the contribution of a fixed amount of property.
The gain recognized is the lesser of the following amounts.
- The excess of:
- The fair market value of the property received in the distribution, over
- The adjusted basis of the partner's interest in the partnership immediately before the
distribution, reduced (but not below zero) by any money received in the distribution.
- The net precontribution gain of the partner. This is the net gain the partner
would recognize if all the property contributed by the partner within 7 years (5 years for
property contributed before June 9, 1997) of the distribution, and held by the partnership
immediately before the distribution, were distributed to another partner, other than a
partner who owns more than 50% of the partnership. For information about the distribution
of contributed property to another partner, see Contribution of Property, under Transactions
Between Partnership and Partners, later.
The character of the gain is determined by reference to the character of the net
precontribution gain. This gain is in addition to any gain the partner must recognize if
the money distributed is more than his or her basis in the partnership.
For these rules, the term money includes marketable securities treated as
money, as discussed earlier.
Effect on basis. The adjusted basis of the partner's
interest in the partnership is increased by any net precontribution gain recognized by the
partner. Other than for purposes of determining the gain, the increase is treated as
occurring immediately before the distribution. See Basis of Partner's Interest, later.
The partnership must adjust its basis in any property the partner contributed within 7
years (5 years for property contributed before June 9, 1997) of the distribution to
reflect any gain that partner recognizes under this rule.
Exceptions. Any part of a distribution that is property the
partner previously contributed to the partnership is not taken into account in determining
the amount of the excess distribution or the partner's net precontribution gain. For this
purpose, the partner's previously contributed property does not include a contributed
interest in an entity to the extent its value is due to property contributed to the entity
after the interest was contributed to the partnership.
Recognition of gain under this rule also does not apply to a distribution of unrealized
receivables or substantially appreciated inventory items if the distribution is treated as
a sale or exchange, as discussed earlier.
Partner's Basis for
Distributed Property
Unless there is a complete liquidation of a partner's interest, the
basis of property (other than money) distributed to the partner by a partnership is
its adjusted basis to the partnership immediately before the distribution. However, the
basis of the property to the partner cannot be more than the adjusted basis of his or her
interest in the partnership reduced by any money received in the same transaction.
Example 1. The adjusted basis of Beth's partnership interest is
$30,000. She receives a distribution of property that has an adjusted basis of $20,000 to
the partnership and $4,000 in cash. Her basis for the property is $20,000.
Example 2. The adjusted basis of Mike's partnership interest is
$10,000. He receives a distribution of $4,000 cash and property that has an adjusted basis
to the partnership of $8,000. His basis for the distributed property is limited to $6,000
($10,000 - $4,000, the cash he receives).
Complete liquidation of partner's interest. The basis of property received in complete liquidation of a partner's interest
is the adjusted basis of the partner's interest in the partnership reduced by any
money distributed to the partner in the same transaction.
Partner's holding period. A partner's holding period for property
distributed to the partner includes the period the property was held by the partnership.
If the property was contributed to the partnership by a partner, then the period it was
held by that partner is also included.
Basis divided among properties. If the basis of property received is
the adjusted basis of the partner's interest in the partnership (reduced by money received
in the same transaction), it must be divided among the properties distributed to the
partner. For property distributed after August 5, 1997, allocate the basis using the
following rules.
- Allocate the basis first to unrealized receivables and inventory items included in the
distribution by assigning a basis to each item equal to the partnership's adjusted basis
in the item immediately before the distribution. If the total of these assigned bases
exceeds the allocable basis, decrease the assigned bases by the amount of the excess.
- Allocate any remaining basis to properties other than unrealized receivables and
inventory items by assigning a basis to each property equal to the partnership's adjusted
basis in the property immediately before the distribution. If the allocable basis exceeds
the total of these assigned bases, increase the assigned bases by the amount of the
excess. If the total of these assigned bases exceeds the allocable basis, decrease the
assigned bases by the amount of the excess.
Allocating a basis increase. Allocate any basis increase
required in rule (2), above, first to properties with unrealized appreciation to the
extent of the unrealized appreciation. (If the basis increase is less than the total
unrealized appreciation, allocate it among those properties in proportion to their
respective amounts of unrealized appreciation.) Allocate any remaining basis increase
among all the properties in proportion to their respective fair market values.
Example. Julie's basis in her partnership interest is $55,000.
In a distribution in liquidation of her entire interest, she receives properties A and B,
neither of which is inventory or unrealized receivables. Property A has an adjusted basis
to the partnership of $5,000 and a fair market value of $40,000. Property B has an
adjusted basis to the partnership of $10,000 and a fair market value of $10,000.
To figure her basis in each property, Julie first assigns bases of $5,000 to property A
and $10,000 to property B (their adjusted bases to the partnership). This leaves a $40,000
basis increase (the $55,000 allocable basis minus the $15,000 total of the assigned
bases). She first allocates $35,000 to property A (its unrealized appreciation). The
remaining $5,000 is allocated between the properties based on their fair market values.
$4,000 ($40,000/$50,000) is allocated to property A and $1,000 ($10,000/$50,000) is
allocated to property B. Julie's basis in property A is $44,000 ($5,000 + $35,000 +
$4,000) and her basis in property B is $11,000 ($10,000 + $1,000).
Allocating a basis decrease. Use the following rules to
allocate any basis decrease required in rule (1) or rule (2), earlier.
- Allocate the basis decrease first to items with unrealized depreciation to the extent of
the unrealized depreciation. (If the basis decrease is less than the total unrealized
depreciation, allocate it among those items in proportion to their respective amounts of
unrealized depreciation.)
- Allocate any remaining basis decrease among all the items in proportion to their
respective assigned basis amounts (as decreased in (1)).
Example. Tom's basis in his partnership interest is $20,000. In
a distribution in liquidation of his entire interest, he receives properties C and D,
neither of which is inventory or unrealized receivables. Property C has an adjusted basis
to the partnership of $15,000 and a fair market value of $15,000. Property D has an
adjusted basis to the partnership of $15,000 and a fair market value of $5,000.
To figure his basis in each property, Tom first assigns bases of $15,000 to property C
and $15,000 to property D (their adjusted bases to the partnership). This leaves a $10,000
basis decrease (the $30,000 total of the assigned bases minus the $20,000 allocable
basis). He allocates the entire $10,000 to property D (its unrealized depreciation). Tom's
basis in property C is $15,000 and his basis in property D is $5,000 ($15,000 - $10,000).
Distributions before August 6, 1997. For property
distributed before August 6, 1997, allocate the basis using the following rules.
- Allocate the basis first to unrealized receivables and inventory items included in the
distribution to the extent of the partnership's adjusted basis in those items. If the
partnership's adjusted basis in those items exceeded the allocable basis, allocate the
basis among the items in proportion to their adjusted bases to the partnership.
- Allocate any remaining basis to other distributed properties in proportion to their
adjusted bases to the partnership.
Partner's interest more than partnership basis. If the
basis of a partner's interest to be divided in a complete liquidation of the partner's
interest is more than the partnership's adjusted basis for the unrealized receivables and
inventory items distributed, and if no other property is distributed to which the partner
can apply the remaining basis, the partner has a capital loss to the extent of the
remaining basis of the partnership interest.
Special adjustment to basis. A
partner who acquired any part of his or her partnership interest in a sale or exchange or
upon the death of another partner may be able to choose a special basis adjustment
for property distributed by the partnership. To choose the special adjustment, the partner
must have received the distribution within 2 years after acquiring the partnership
interest. Also, the partnership must not have chosen the optional adjustment to basis,
discussed later under Adjusting the Basis of Partnership Property, when the
partner acquired the partnership interest.
If a partner chooses this special basis adjustment, the partner's basis for the
property distributed is the same as it would have been if the partnership had chosen the
optional adjustment to basis. However, this assigned basis is not reduced by any depletion
or depreciation that would have been allowed or allowable if the partnership had
previously chosen the optional adjustment.
The choice must be made with the partner's tax return for the year of the distribution
if the distribution includes any property subject to depreciation, depletion, or
amortization. If the choice does not have to be made for the distribution year, it must be
made with the return for the first year in which the basis of the distributed property is
pertinent in determining the partner's income tax.
A partner choosing this special basis adjustment must attach a statement to his or her
tax return that the partner chooses under section 732(d) of the Internal Revenue Code to
adjust the basis of property received in a distribution. The statement must show the
computation of the special basis adjustment for the property distributed and list the
properties to which the adjustment has been allocated.
Example. Bob purchased a 25% interest in X partnership for
$17,000 cash. At the time of the purchase, the partnership owned inventory having a basis
to the partnership of $14,000 and a fair market value of $16,000. Thus, $4,000 of the
$17,000 he paid was attributable to his share of inventory with a basis to the partnership
of $3,500.
Within 2 years after acquiring his interest, Bob withdrew from the partnership and for
his entire interest received cash of $1,500, inventory with a basis to the partnership of
$3,500, and other property with a basis of $6,000. The value of the inventory received was
25% of the value of all partnership inventory. (It is immaterial whether the inventory he
received was on hand when he acquired his interest.)
Since the partnership from which Bob withdrew did not make the optional adjustment to
basis, he chose to adjust the basis of the inventory received. His share of the
partnership's basis for the inventory is increased by $500 (25% of the $2,000 difference
between the $16,000 fair market value of the inventory and its $14,000 basis to the
partnership at the time he acquired his interest). The adjustment applies only for
purposes of determining his new basis in the inventory, and not for
purposes of partnership gain or loss on disposition.
The total to be allocated among the properties Bob received in the distribution is
$15,500 ($17,000 basis of his interest - $1,500 cash received). His basis in the inventory
items is $4,000 ($3,500 partnership basis + $500 special adjustment). The remaining
$11,500 is allocated to his new basis for the other property he received.
Mandatory adjustment. A
partner does not always have a choice of making this special adjustment to basis.
The special adjustment to basis must be made for a distribution of
property, (whether or not within 2 years after the partnership interest was acquired) if
all the following conditions existed when the partner received the partnership interest.
- The fair market value of all partnership property (other than money) was more than 110%
of its adjusted basis to the partnership.
- If there had been a liquidation of the partner's interest immediately after it was
acquired, an allocation of the basis of that interest under the general rules (discussed
earlier under Basis divided among properties) would have decreased the basis of
property that could not be depreciated, depleted, or amortized and increased the basis of
property that could be.
- The optional basis adjustment, if it had been chosen by the partnership, would have
changed the partner's basis for the property actually distributed.
Required statement. Generally, if a partner chooses a special basis
adjustment and notifies the partnership, or if the partnership makes a distribution for
which the special basis adjustment is mandatory, the partnership must provide a statement
to the partner. The statement must provide information necessary for the partner to
compute the special basis adjustment.
Marketable securities. A partner's basis in marketable securities
received in a partnership distribution, as determined in the preceding discussions, is
increased by any gain recognized by treating the securities as money. See Marketable
securities treated as money under Partner's Gain or Loss, earlier. The basis
increase is allocated among the securities in proportion to their respective amounts of
unrealized appreciation before the basis increase.
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