Partnership depreciation trap.

Under Sec. 708(b)(1)(B), a partnership is considered terminated if, within a 12-month period, there is a sale or exchange of 50% or more of the total interest in partnership capital and profits. Thus, if one or more partners sell or exchange interests in a partnership within a 12-month period and the total percentage of transferred interests in both partnership capital and profits is at least 50%, the partnership is technically terminated for tax purposes.

Regs. Sec. 1.708-1(b)(1)(iv) , effective for terminations on or after May 9, 1997, provides that, if a partnership is terminated by a sale or exchange of an interest, the following is deemed to occur: The partnership transfers all of its assets and liabilities to a new partnership in exchange for all of the interests in the new partnership. Immediately thereafter, the terminated partnership distributes the interests in the new partnership to the partners who purchased the interests in the terminated partnership and the remaining partners in liquidation of the terminated partnership.

Under the current regulations, a termination under Sec. 708(b)(1)(B) no longer results in a deemed distribution of the terminated partnership's assets to the purchasing and remaining partners (as was required under the former regulations). As a result, most of the Federal tax consequences of a Sec. 708(b)(1)(B) termination that resulted from the deemed distribution of assets no longer occur. There will no longer be a reason to be concerned about the possibility of gain recognition under Sec. 731(a), a change in the partnership's basis for its assets or the commencement of a new seven-year period for Secs. 704(c)(1)(B) and 737 purposes (relating to pre-contribution gain).

The revised regulations generally do not alter the Federal tax consequences of the termination of a partnership under Sec. 708(b)(1)(B) to the extent that such consequences did not depend on the deemed distribution of the terminated partnership's assets. For example, the terminated partnership's tax year still will close as a result of the termination and the elections made by the terminated partnership will not be carried over to the new partnership. In addition, the revised regulations do not change the effect of a termination on the depreciation of partnership property by the new partnership. Following a constructive termination, the newly constituted partnership is treated as a new taxpayer and is not bound by the depreciation methods adopted by the terminated partnership. Under Sec. 168(i)(7), property acquired from the terminated partnership will begin a new depreciable life and the depreciable basis of the property will be carried over from the terminated partnership under Sec. 723.

The new partnership may find that acquiring a new depreciable life for its recovery property greatly extends the recovery period.

Example: A terminated partnership is depreciating five-year property with a basis of $1,000. For each of the first three years, the partnership claimed depreciation of $200. At the end of the third year, the partnership terminates under Sec. 708(b)(1)(B). The new partnership now has a basis in the property of $400 and, under Sec. 168(i)(7), a new five-year life. In the first two years after the deemed termination, the partnership's depreciation is limited to $80 ($400/5 years). The continuing partners, who may have played no role in triggering a Sec. 708(b)(1)(13) termination, are at a disadvantage, because they will be entitled to lower depreciation in these two years.

In the example, the shortfall will be made up in years three through five. However, this can result in a substantial current tax liability for the continuing partners in the years immediately following a deemed termination, especially if a terminated partnership has extensive fixed assets. It may be feasible to address this possibility in a partnership agreement so that the continuing partners are somehow compensated for any adverse economic effect of a Sec. 708(b)(1)(B) termination to which they were not a party.

FROM VIJAY SHAH, CPA, RICHARD A. EISNER & COMPANY, L.L.P., NEW YORK, NY