Partners entitled to involuntary conversion proceeds must plan for sec. 1033 relief.

The well-known rule that partnership elections must generally be made by the partnership (Sec. 703(b)) is sometimes overlooked--until it is too late--when a partnership sells property under threat of condemnation. To qualify for Sec. 1033 deferral on partnership property, the partnership must make the election and the partnership must acquire the replacement property.

However, the partners may be focusing on the rewards of "cashing out" their investments, and may be distracted by lengthy litigation over valuation in condemnation proceedings. For partners who would like to reinvest their proceeds and defer gain pursuant to Sec. 1033, liquidating distributions of condemnation proceeds may seal their tax fate. Considerable tax gain may be involved if (1) the court awards a premium for the property (which may be a prime location for renovation or development) and for lost revenue, and (2) buildings on the condemned property have been depreciated to a low basis. The problem of tax consequences arises when proceeds are reinvested at the individual level.

Note: Adverse consequences may follow even if the partners held title to the property as tenants in common, rather than in the partnership's name; see McManus, 583 F2d 443 (9th Cir. 1978) (filing of partnership returns seen as evidence of ownership as partnership; only partnership could make Sec. 1033 election after condemnation).

To make Sec. 1033 treatment available to the individual partners, the partnership must make a liquidating distribution of the property to the partners before the condemnation. Both timing and form of action are key factors. No deeding of title would be required if the property is already held in the names of the partners as individuals. Rather, a distinct book entry would be necessary to show the property's distribution to the partners in satisfaction of their capital interests. (It is assumed that the partners' capital accounts have been maintained accurately.) The property distribution should be followed immediately by the partnership's dissolution.

Such dissolution alone may not be sufficient; see Fuchs, 80 TC 506 (1983), holding that, even though a partnership had dissolved prior to the sale, the partnership had not terminated in accordance with Sec. 708(b), and hence an election to defer gain recognition under Sec. 1033 had to be made at the partnership level. Thus, the partnership should be terminated prior to the date of sale or settlement. This might involve, for example, engaging of counsel in the condemnation litigation by the partners as individuals, closing of partnership bank accounts, and carrying on of activities associated with the property by the collective group of now individual owners. Further, these actions should be completed prior to the year of sale or settlement, so that a final partnership return could be filed, assuming that all partnership activities have "wound up" in accordance with Sec. 708(b).

If all steps are completed properly, the property in the hands of the individuals would carry the adjusted basis of their partnership interests at the date of distribution reduced by any money received in liquidation. On receipt of the sale or settlement proceeds, each individual then could elect Sec. 1033 treatment for proceeds reinvested in accordance with the requirements of that provision.