Partnerships Like-Kind Exchange Dilemma?

Sec. 1031(a)(1) provides that no gain or loss is recognized on an exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for like-kind property to be held either for productive use in a trade or business or for investment. The taxpayer recognizes gain only to the extent of money or other property received in the exchange.

Regs. Sec. 1.1031(b)-1(c) states that consideration received in the form of an assumption of liabilities (or a transfer subject to a liability) is to be treated as other property or money. When each party to an exchange either assumes the other partys liability or acquires property subject to a liability, in determining the amount of other property or money, consideration given in the form of an assumption of liabilities (or the receipt of property subject to a liability) is offset against consideration received in the form of an assumption of liability (or transfer subject to a liability).

Example: B has a $40,000 adjusted basis in real property X, which has a $100,000 fair market value (FMV) and is encumbered by a $30,000 mortgage. On May 17, 1991, B transfers X to C, who assumes the mortgage. On July 5, 1991, C transfers real property V, which is encumbered by a $20,000 mortgage and has a $90,000 FMV, to B, who assumes the mortgage. The consideration B received in the form of the liability C assumed ($30,000) is offset by the consideration B gave by assuming the $20,000 liability; the net amount, $10,000, is treated as money or other property. Thus, B recognizes $10,000 gain; see Regs. Sec. 1.1031(k)-1(j)(3), Example (5).

Under Sec. 752(b), any decrease in a partners share of partnership liabilities is treated as the partnerships distribution of money to the partner. The partner must recognize income to the extent that the deemed distribution exceeds his or her adjusted basis in his or her partnership interest (immediately before the deemed distribution); see Sec. 731(a). Conversely, under Sec. 752(a), any increase in a partners share of partnership liabilities is treated as the partners contribution of money to the partnership.

Potential Problem

Based on the interplay of Secs. 1031 and 752, when an exchange straddles two years, partners could realize income in the year the partnership relinquishes property subject to debt, even though, in the following year, the entity timely receives replacement property encumbered by debt equal to or greater than the relinquished propertys debt.

In Rev. Rul. 2003-56, the IRS resolved this potential problem with a pro-taxpayer ruling. The ruling covers two situations.

Situation 1: P, a general partnership with two equal partners, owns Property 1 with a $300 FMV and $80 adjusted basis; the property is subject to a $100 liability. P enters into a deferred like-kind exchange and transfers the property subject to the liability. In the following year, P receives Property 2, which has a $260 FMV and is subject to a $60 liability. Thus, P has a $40 net decrease in liabilities.

Situation 2: The facts are the same as in Situation 1, except that Property 2 has a $340 FMV and is subject to a $140 liability, resulting in a $40 net increase in liabilities.

Solution

In the ruling, the IRS concluded that if a partnership enters into a Sec. 1031 deferred like-kind exchange in which property subject to a liability is transferred in one partnership tax year and property subject to a liability is received in the following tax year, the liabilities are netted for Sec. 752 purposes; any decrease in partnership liabilities is taken into account for Sec. 752(b) purposes in the partnerships first tax year.  In effect, for purposes of the partnership tax rules, the replacement property is treated as having been received in the same partnership tax year in which the relinquished property was given up.

Applying the above conclusions to Situation 1, the IRS ruled that Ps amount realized is $300 (the FMV of the replacement property ($260), increased by the relinquished liability ($100) and decreased by the replacement liability ($60)). Ps adjusted basis in the relinquished property is $80; thus, it realizes $220 gain. Because the $100 relinquished liability is offset by the $60 replacement liability, P is treated as receiving $40 of money or other property; thus, it recognizes a $40 gain in year 1, which is allocated $20 to each partner (as part of his or her distributive share of Ps year 1 income). Addi-
tionally, under Sec. 752(b), each partner is treated as receiving a $20 deemed distribution from P in year 1, which is treated as an advance or draw to the extent of each partners distributive share of Ps year 1 income.

The IRS also ruled that when an exchange of two encumbered properties straddles two years, any net increase in a partners share of partnership liability is taken into account for Sec. 752(a) purposes in the partnerships second tax year. Applying this conclusion to Situation 2, the IRS ruled that Ps amount realized is $300 (the replacement propertys FMV ($340), increased by the relinquished liability ($100) and decreased by the replacement liability ($140)). As in Situation 1, Ps realized gain is $220. Because the $100 relinquished liability is offset by the $140 replacement liability in determining the money or other property P is treated as receiving, P is not treated as having received money or other property and, thus, recognizes no gain in year 1. Further, under Sec. 752(a), each partner is treated as having made a $20 contribution to P in year 2.

From Charles Daniel, CPA, New York, NY