Understanding the mechanics of minimum gain.

Editor's note: This case study has been adapted from "PPC Tax Planning Guide-Partnerships," 18th Edition, by James A. Keller, William D. Klein, Sara S. McMurrian and Linda A. Markwood, published by Practitioners Publishing Company, Fort Worth, TX, 2004 ([phone]; www.ppcnet.com)

Minimum gain is the amount by which a partnership's nonrecourse liabilities exceed the book basis of the property securing the liability. According to Regs. Sec. 1.704-2(d)(1), a partnership's minimum gain is the total minimum gain for all partnership property subject to nonrecourse liabilities. If a property is subject to two or more liabilities of equal security priority, the property's basis is allocated among the liabilities in proportion to their outstanding balances. Otherwise, the property's basis is allocated first to liabilities of superior security priority. Basis is allocated to an inferior liability only when it exceeds the principal amount of superior liabilities. Under Regs. Sec. 1.704-2(d)(2), only the portion of the basis allocated to a nonrecourse liability is used in determining minimum gain.

Sources of Minimum Gain

Minimum gain usually arises in one of two ways:

1. The depreciation or amortization of property causes the book basis to fall below the nonrecourse liability secured by the property.

2. The partnership refinances the property, (or obtains a second mortgage) and, as a result, the nonrecourse liability exceeds the book basis of the property securing it.

Minimum gain can decrease in a number of ways, including:

1. The nonrecourse liability's principal is paid down.

2. A previously nonrecourse liability is converted into a recourse one.

3. The property securing the nonrecourse debt is revalued in a mandatory or optional bookup.

Example

Fats and Waller are equal general partners in Music Partners, to which they each contributed $10,000. On January 1 of year 1, they acquired a concert hall for $390,000 (on leased land). The partnership paid $20,000; the seller fully financed the purchase via a nonrecourse loan secured by the building. The loan required payments of interest only for five years, then was payable in full.

In each of the first three years, the partnership's net loss was $10,000, resulting completely from depreciation. The partnership agreement complies with the safe-harbor allocation rules; each partner is obligated to restore his negative capital account on liquidation. The agreement also has a minimum-gain charge back provision.

Year 1: At the end of year 1, the property's basis is $380,000; the total nonrecourse financing is $370,000. If the property is sold in a fully taxable transaction in satisfaction of the non recourse liability., there would be no gain; thus, there is no minimum gain and no nonrecourse deductions for the year.

Year 2: At the end of year 2, the property's basis is $370,000; the total nonrecourse liabilities secured by the property is $370,000. Thus, the property's disposition in satisfaction of the nonrecourse liability would produce no minimum gain.

Year 3: At the end of year 3, the property's basis is $360,000, and the total nonrecourse liabilities secured by the property is still $370,000. Thus, the property's disposition in satisfaction of the nonrecourse liability would produce a $10,000 gain. Because there was no minimum gain as of the beginning of the year, the increase in minimum gain is $10,000 for the year and there is $10,000 in nonrecourse deductions. The $10,000 of depreciation is characterized as nonrecourse deductions.

Because in year 3, the nonrecourse deductions are allocated in the same manner as are other deductions (50% to each partner), and the allocations of deductions other than the nonrecourse deductions have substantial economic effect, the allocation of the nonrecourse deductions in the manner provided is permitted. Nonrecourse allocations are treated as reducing the partners' capital accounts. Each partner has an offsetting allocation of $5,000 of minimum gain.

Year 4: In year 4, Fats needs additional tax deductions; thus, the partners agree to allocate 80% of the depreciation deductions to Fats and 20% to Waller. At the end of that year, the building's basis is $350,000, while the nonrecourse liabilities remain at $370,000. There is a $10,000 increase in minimum gain and the depreciation is characterized as a nonrecourse deduction. Under the safe--harbor pro visions for allocating nonrecourse deductions in Regs. Sec. 1.704-2(e)(2) and -2(m), Example 1(ii), the allocation must be consistent with an allocation of some other significant item having substantial economic effect related to the property securing the nonrecourse deduction. Because all allocations other than depreciation in the third year are allocated 50%/50%, an allocation of the nonrecourse deductions in any other manner would not be allowed under the safe-harbor provision. While it could be argued that the allocation is permissible under the partners' interests in the partnership rules, such an argument would have little chance of success under the facts.

Conclusion

The partners should have amended the partnership agreement in year 4 to allocate Fats 80% of the depreciation deductions and 80% of all property appreciation over $50,000 (i.e., a sale above $440,000). (Assume that the partnership has a reasonable expectation that the property will appreciate in excess of $50,000.) If they had, because the allocation of nonrecourse deductions is reasonably consistent with other allocations as to the property securing the nonrecourse liability and which have substantial economic effect, it is likely that the 80% allocation of the nonrecourse deductions to Fats would have been allowed.

Editor:

Albert B. Ellentuck, Esq.

Of Counsel

King & Nordlinger, L.L.P.

Arlington, VA