Partnership's ownership of residence does not deny sec. 121 exclusion.

In Letter Ruling 200004022, the IRS ruled that, for purposes of applying the Sec. 121 residence sale exclusion, a husband and wife were the owners of a residence during all periods that the property was titled in a partnership. The facts of the ruling indicate that title to the residence was distributed before any sale, but the ruling should also apply to a residence titled in the partnership at the time of sale.

In the ruling, a husband and wife initially owned a residence. They transferred title of 98% of the residence to a trust that qualified as a grantor trust under Secs. 671-678. The trust then transferred its 98% interest in the residence to a partnership, in which the trust held a 98% interest as a limited partner. The husband and wife also transferred their remaining 2% interest in the residence to the same partnership, in which they each held a 1% general partnership interest. The husband and wife also transferred several small rental properties to the partnership.

Sec. 121(a) provides for an exclusion of gain realized from the sale or exchange of property that has been owned and used as the taxpayer's principal residence for two of the five years preceding the sale. The issue in the ruling was whether the husband and wife would be treated as the owners of the residence during the time the property was titled in the partnership. Rev. Ruls. 66-159 and 85-45 held that the beneficiary of a grantor trust is treated as the owner of a residence titled in the trust for purposes of former Secs. 121 (exclusion of gain realized by a taxpayer age 55 or older) and 1034 (rollover of proceeds realized from sale of a principal residence). Thus, the unanswered issue in Letter Ruling 200004022 was whether, for purposes of the residence sale provision, ownership through a partnership could be imputed to the partners.

The facts of the ruling indicate that the residence was not used for conducting an enterprise, did not yield any income or produce any business deductions to the partnership or to the partners, and served no business purpose to the partnership or to the partners. Also, it was noted that the husband and wife owned 100% of the residence (either through the partnership or the grantor trust), at all times that title was held in the partnership.

The IRS analyzed the issue in light of the definition of a partnership found in Culbertson, 337 US 733 (1949), and Tower, 327 US 280 (1946), which generally require that for a partnership to exist for tax purposes, the parties must join together to carry on an enterprise and agree to divide the profits and losses. Under this definition, it could be argued that no partnership existed for the ownership of the residence. The Service did not explicitly reach this conclusion, because the partnership also held title to several rental properties, which would presumably require the entity to be respected as a partnership, at least for the rental properties.

Letter Ruling 200004022 may be of interest to farmers and ranchers who hold title in limited liability companies (LLCs) to property that consists of both business-use property and a family residence. Such taxpayers are often advised to hold business-use property in an entity such as an LLC to reduce legal liability. If the property acquired consists of a ranch and a ranch house that will be used as a personal residence, it is difficult to ask for separate deeds so that the ranch property may be transferred to the LLC and the residence held by the taxpayers individually. A deed description of a house and the adjacent two acres, for example, may be too indefinite to be effective for local law. A subsequent purchaser of the ranch and the ranch house may also ask for a single deed for the entire property.

A tax adviser might suggest that, to provide a liability shield and avoid ownership by a partnership, title to the entire property be held in a single-member limited liability company (SMLLC) disregarded as a separate entity under Regs. Sec. 301.7701-3(b). However, creating a SMLLC is a practical difficulty in a community property jurisdiction or a separate property jurisdiction in which husband and wife have joint ownership of the residence.

Under the reasoning of Letter Ruling 200004022, it appears that the ownership test of Sec. 121(a) may be satisfied if title to ranch property, including a ranch house, is transferred to a partnership or an LLC. It is also necessary that the residence be treated as personal-use property for which no business deductions are claimed through the duration of ownership by the entity. Although the entity may be respected as a partnership for tax purposes (because it is also carrying on a ranching business), Letter Ruling 200004022 appears to apply an aggregate view to the ownership of the residence. There appears to be no reason why the conclusion of the ruling would change if the property were sold when title is held by the partnership.

FROM JAMES R. HAMILL, CPA, PH.D., ANDERSON SCHOOL AND GRADUATE SCHOOL OF MANAGEMENT, UNIVERSITY OF NEW MEXICO, ALBUQUERQUE, NM (NOT ASSOCIATED WITH KPMG LLP)