Capital gain treatment for gains on sales between partnerships and related parties.

Facts

Ralph and Ed, unrelated persons, are the partners of Honeymoon Village, which owns and operates several apartment buildings. Ralph has a 55% interest in Honeymoon Village's capital, profits and losses. Ed owns the other 45%. Individually, Ralph also owns several apartment buildings. One of Ralph's properties, 100 Kramden Street, has appreciated significantly since Ralph purchased it for $250,000. Ralph's purchase price was allocated $200,000 to the building and $50,000 to the land. The estimated fair market values (FMVs) of the building and land are now $350,000 and $70,000, respectively. Due to depreciation, Ralph's basis in the building is $145,000. (There is no potential recapture because straight-line depreciation was used.)

Ralph has incurred capital losses from nonbusiness bad debts and would like to use these capital losses to offset capital gains from the sale of some of his properties. Ralph has suggested to his tax adviser that the Kramden Street property be sold to Honeymoon Village for its $420,000 FMV. Ed believes that the property is valuable and is agreeable to the transaction.

Issue

Will Ralph recognize capital gain on the sale of 100 Kramden Street to Honeymoon Village?

Editor's note: This case study has been adapted from PPC Tax Planning Guide--Partnerships, 7th Edition, by Grover A. Cleveland, William D. Klein, Richard D. Thorsen and Philip H. Welch, published by Practitioners Publishing Company, Fort Worth, Tex. 1993.

Analysis

Generally, transactions between partnerships and partners acting in a nonpartner capacity are treated as transactions between unrelated parties. An exception, however, affects the taxation of sales of property if the property is not a capital asset in the transferee's hands. Under this exception, recognized gain is recharacterized from capital gain to ordinary income in the case of a direct or indirect sale of property between the following persons: 1. A partnership and a person owning, directly or indirectly, more than 50% of the partnership's capital or profits interests. 2. Two partnerships in which the same persons own, directly or indirectly, more than 50% of the capital or profits interests.

The exception applies if the property in the transferee's hands is not a "capital asset" as defined in the Code. Any gain recognized is taxed as ordinary income.

Sec. 1239 denies capital gain treatment for gain from related party sales of property that is depreciable in the transferee's hands. For this purpose, related parties include a person and all entities controlled by or for such person. The following are considered to be controlled entities. 1. A corporation and a person owning more than 50% of the value of its outstanding stock. 2. A partnership and a person having an interest of more than 50% in its capital or profits.

Constructive ownership rules apply in measuring the person's ownership.

Ralph owns more than 50% of the capital and profits interest of Honeymoon Village. Honeymoon Village intends to continue operating 100 Kramden Street as an apartment building, so the property would constitute property used in a trade or business (Sec. 1231 property), rather than a capital asset.

If Ralph sells 100 Kramden Street to Honeymoon Village, his entire gain of $225,000 will be ordinary income and Ralph will not be able to use any of his capital losses to offset this income.

Ralph's tax adviser should advise against such a sale. He should instead suggest that Ralph sell 100 Kramden Street (or other appreciated assets) to an unrelated party, or that Ralph reduce his capital and profits interest in Honeymoon Village to 50% or less. If Ralph and Ed are not interested in changing their interests in Honeymoon Village, the tax adviser might suggest that Ralph sell a 45% undivided interest in the property to Ed for $189,000 (45% of its FMV). Ralph would recognize a capital gain of $101,250 ($189,000 less 45% of his $195,000 basis). After the sale, Ralph and Ed could jointly contribute the property to Honeymoon Village. These transactions would at least partially accomplish Ralph's and Ed's goals.

Conclusion

Gains on sales or exchanges of property between related partnerships or a partnership and a substantial partner are taxed as ordinary income if the property is not a capital asset in the transferee's hands. Ralph's gain on his proposed sale of 100 Kramden Street will be taxed as ordinary income unless he implements one of the suggested alternatives.