Discussion:Partnership Allocation of unrecaptured 1250 gains

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Discussion Forum Index --> Tax Questions --> Partnership Allocation of unrecaptured 1250 gains


Dfmcpa (talk|edits) said:

5 September 2007
What is the proper allocation of unrecaptured 1250 gains among partners when a partner was admitted to the partnership one year ago while the original partners have been members for the entire 10 year period during which the residential rental building was held before sale?

Wcmcm (talk|edits) said:

5 September 2007
Refer to 704(b) for book/tax allocations. You should find that the 1250 recapture will go primarily to the original partners. Did you record a 704(c) capital book-up?

Dfmcpa (talk|edits) said:

6 September 2007
Without referring to code sections, is it your opinion that the unrecaptured 1250 gains are allocated based on partnership profit and loss percentages AND a weighted average based on length of ownership? Then how would you handle that portion of the unrecaptured 1250 gain that would have been attributable to a partner who was in and out way before the sale and creation of the unrecaptured 1250 gain?

Wcmcm (talk|edits) said:

6 September 2007
It is my opinion that the newly admitted partner is allocated gain and related 1250 recapture based on the gain realized from the time they were admitted. This applies to all partners and is the reason to maintain capital accounts in accordance with the regs for tax and book. This will result in equitable allocations for all partners.

Dfmcpa (talk|edits) said:

8 September 2007
Thank you Wcmcm, but what about the second part of my question. Who is allocated the unrecaptured 1250 gain allocated to the partner who was in and out way before the sale?

Wcmcm (talk|edits) said:

8 September 2007
2nd verse same as the 1st

Dfmcpa (talk|edits) said:

10 September 2007
Wcmcm, your answer is appreciated,
but not helpful. When the partnership sells real estate, unrecaptured 1250 gains are calculated and generally taxed at 25% instead of 15%. When allocating the amount of unrecaptured 1250 gains, what happens to the amount that is attributable to those partners who are no longer in the partnership. i. e. sold out before the sale? 1. We go find them! 2. All is allocated to the existing partners. 3. The amount properly allocated to the former partners is forgotten.

Wcmcm (talk|edits) said:

11 September 2007
How were the former partners removed from the partnership? Was a 754 election filed?

All is allocated to the existing partners. No phantom gain with stepped-up basis allocations, which sounds applicable. Give me more history & details for a more insightful/helpful response.

FTF65 (talk|edits) said:

September 11, 2007
DFM - check out Reg. 1.1(h)-1(b)(3)(ii). This section generally provides that when a partnership interest that has been held for more than a year is sold or exchanged, the selling partner must pick up their allocable share (including sec. 704(c) remedial allocations) of the partnership's total unrecaptured 1250 gain. The partnership's total unrecaptured 1250 gain is computed as if the partnership hypothetically disposed of all its section 1250 property in a fully-taxable transaction for cash equal to the FMV of the assets immediately before the transfer of the partnership interest. The amount of the partner's "residual" gain from the sale of their interest is computed by subtracting their share of the hypothetical unrecaptured 1250 gain from their total gain/loss on sale. This can produce some unexpected results. For example, assume a partner with long-term basis of $10k sells their interest for $20k. Also assume that the partner's allocable share of the partnership's unrecaptured 1250 gain is $20k. These facts result in the selling partner having unrecaptured 1250 gain of $20k and a long-term capital loss of $10k.

The last sentence of Reg. 1.1(h)-1(b)(3)(ii) is also worth mentioning. This sentence provides that the above "recapture" rules do not apply to redemptions of partnership interests. This means that a redeemed partner does not have to recognize their allocable share of the partnership's unrecaptured 1250 gain. Accordingly, assuming the same facts as the above example, the selling partner would have $10k of long-term capital gain.

Reg. 1.1(h)-1(e) provides that reporting rules similar to those under Reg. 1.751-1(a)(3) shall apply to sales or exchanges of partnership interests in which the selling partners recognize section 1250 capital gain [presumably this also applies to unrecaptured 1250 gain(?)].

Wcmcm (talk|edits) said:

11 September 2007
Great analysis as usual FTF. Doesn't 743(b) reduce the 1250 recapture to the newly admitted partner?

FTF65 (talk|edits) said:

September 11, 2007
Wcmcm - assuming that a 754 election were made and that there was a gain on the sale of the interest (i.e., FMV of interest was greater than inside basis), then "yes" the 743(b) adjustment should reduce the amount of unrecaptured 1250 gain to a newly admitted partner (for that matter, it should reduce ANY future gain). I think where things could get a little weird is if the partnership doesn't make a sec. 754 election and doesn't liquidate in the same year that it sells its 1250 asset (i.e., could the result be that the newly admitted partner gets allocated unrecaptured 1250 gain year 1 and then gets a long-term capital loss in year 2 when the partnership is liquidated?)

Dfmcpa (talk|edits) said:

11 September 2007
Wcmcm and FTF65: In summary, you need to calculate each year the cumulative hypothetical unrecaptured 1250 gain (even though there might not be any when the asset is sold but unlikely) and allocate to partners at the earlier of 1. Sale or death (but not redemption) and 2. Sale of the asset. Then each partner is allocated only his pro rata share of the unrecaptured 1250 gain for only the time he was a partner. Finally, since the unrecaptured 1250 gain is not allocated to a partner who redeems his interest, what happens to it? Are you saying the total amount as reported by the partnership will be greater than the amount allocated to the existing partners?

JAD (talk|edits) said:

11 September 2007
I have never understood the underlying reason for the difference in treatment of unrecaptured 1250 depreciation between a sale and a redemption of a partnership interest. Any thoughts?

FTF65 (talk|edits) said:

September 12, 2007
DFM – “in theory,” if a partner is selling their interest in a partnership that has Sec. 1250 property, then the partnership needs to:

1. Compute the gain from a hypothetical sale of its Sec. 1250 property using the estimated FMV of such property as of the date immediately before the partner sells their interest;


2. Allocate to the selling partner their share of such unrecaptured 1250 gain so that such partner can compute how much of the gain from the sale of their interest is subject to the 25% rate;
 and,

3. Reduce the amount of unrecaptured 1250 gain by the amount recaptured in item 2 (this is a presumption, the Regs do not address).

Does this happen in practice? It probably happens about as much as recording 1245 recapture as a “hot asset” for purposes of Sec. 751(a) (i.e., it doesn’t happen very often). Because there could be a lot of work involved with tracking the unrecaptured 1250 gain and because many clients do not want to do the tracking or pay someone else to do it for them, this probably falls through the cracks more often than not.

Regarding the redemption, consider this simplified example: assume individuals A, B & C form equal partnership ABC by each contributing $1,000 which is used to purchase a $3,000 Sec. 1250 asset. Depreciation is $300 per year for 10 years. At the end of year two when the adjusted basis of the asset is $2,400, the partnership redeems C’s interest for $1,000 resulting in C having a $200 gain. Assuming the FMV of the asset is $3,000 immediately before the redemption, a hypothetical sale of such asset results in C having an allocable share of unrecaptured 1250 gain of $200; however, since Reg, 1.1(h)-1(b)(3)(ii) does not apply to redemptions, presumably C’s $200 gain is all capital gain. Now, assume that ABC sells the asset at the end of year 3 for $4,000 resulting in a gain of $1,900. This gain breaks down as $900 of unrecaptured 1250 gain and $1,000 of capital gain. Clearly, by exiting the partnership via redemption, partner C has shifted some of his 25% tax to partners A and B even though C got the benefit of the depreciation deductions. If this is the way the rules were intended to work, they do not seem particularly fair [side note: a sec. 754 election in this case would not solve A & B's unrecaptured 1250 problem]. 



JAD - the preamble to the final 1.1.(h) Regs [T.D. 8902] sheds some light as to why partner redemptions were excepted - apparently the Treasury and the IRS felt that a redemption would unnecessarily complicate the application of these rules by activating the Sec. 751(b) disproportionate distribution provisions. Here is a direct quote from the preamble: “some practitioners have expressed concern that the look- through capital gains provisions of the proposed regulations apply to the redemption of a partnership interest. To apply the regulations in the context of redemptions, it would be necessary to import the concepts utilized in section 751(b). Treasury and the IRS believe that this would not be advisable. Accordingly, these regulations do not apply to any transaction that is treated as a redemption of a partnership interest for Federal income tax purposes.”

Dfmcpa (talk|edits) said:

12 September 2007
FTF65, thank you very much for your excellent response. Instead of a redemption, if you had a death of a partner, do you believe the 25% tax is shifted to the original partners or does the new partner( wife of the deceased) get "stuck" with her husbands 25% tax, or is it not allocated to anyone?

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