Question: I am a partner in a two-person partnership which holds two condominium units for rental. Can we dissolve our partnership without paying tax on the appreciation in the condominium units?
Answer: Although partnerships are not subject to Federal income taxes, partnership income passes through to and is reported by the partners on their Federal income tax returns. If and when a partnership recognizes income or loss, that income or loss is taxable to or deductible by the partners on their personal income tax returns, subject to various limitations on loss deductions. As is the case with individuals, no tax is imposed on the appreciation of assets held by a partnership until the assets are sold at which time the gain is recognized and taxed.
If the partnership sells the two condominium units, the gain will pass through to and be reported by you and your partner as taxable income. The gain will be taxed as capital gain or ordinary income depending on the nature of the property in the hands of the partnership, be it inventory or business or investment property. Previous deductions taken by the partnership such as depreciation may be recaptured and taxed as ordinary income.
It is often assumed that upon a liquidation and dissolution of a business, a sale or disposition of the entity’s assets is required, thereby resulting in tax consequences. In fact, if the partnership holds assets other than cash, the assets can be distributed in-kind to the partners in accordance with their percentage interests. By doing so, the unrealized appreciation in the distributed assets will not be taxable to the partners when the distribution is made.
The partners who receive in-kind distributions of partnership assets will take the same basis in those assets for income tax purposes that the partners have in their partnership interests. This means that the appreciation in the distributed assets, while not taxed at the time of distribution to the partners, will be taxed if the partners sell such assets assuming the eventual sale price exceeds the basis in the assets sold. Nevertheless, if a partner holds a distributed asset until the partner’s death, the appreciation in the asset received in the partnership liquidation will never be taxed as the basis of an asset received at death is increased to the fair market value of the asset on death, thereby resulting in a permanent avoidance of tax on the appreciation.
There are some circumstances whereby assets distributed in-kind to partners are taxable, the general rules notwithstanding. If, for example each of you and your partner contributed one of the condominium units to the partnership and, on liquidation, each of you received the unit contributed by the other, gain may have to be recognized. These so-called mixing bowl transactions are exceptions to the nonrecognition of gain rule on in-kind distributions.
Contrast the situation with what occurs if cash is distributed by the partnership in liquidation. In this case, gain must be recognized by each partner based on the difference between the cash received and the partner’s basis in his or her partnership interest. For this purpose, publicly-traded securities are treated as cash. If you do not receive cash nor publicly-traded securities, the liquidating distribution will not fall within this exception.
Partnerships enjoy a tax advantage that corporations do not as distributions of appreciated corporate assets to shareholders will result in the recognition of gain. For this reason, partnerships are often the preferred vehicle for holding real estate assets which tend to appreciate in value over the long-term. In your case, since the appreciated real estate is already held in a partnership, you can readily take advantage of this tax deferral opportunity.
The Tax Corner addresses various tax, estate, asset protection and other business matters. Should you have any questions regarding the subject matter or if you have questions you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to email@example.com.