Selling a Real Estate Partnership Interest

An investor owns a stake in a partnership that holds an apartment building. A buyer offers $1 million in cash for the interest, and the investor starts thinking about what to do with the money. Then the projection comes back from the tax preparer: taxable gain of more than $2 million, and a federal tax bill that eats a large share of the cash. Nothing went wrong. The partnership simply borrowed against the building over the years, deducted depreciation, and distributed cash, and the sale is where all of that catches up.

Selling a partnership interest is not like selling stock. The amount you realize, the character of your gain, and what happens to old losses all follow rules written specifically for partnerships. Here is what to review before you sign a letter of intent.

Debt Relief Counts as Sale Proceeds

When you sell a partnership interest, your share of the partnership's liabilities goes with it. Under Section 752(d) and Treas. Reg. §1.752-1(h), the reduction in your share of partnership liabilities is treated as an amount realized under Section 1001. The same rule applies to both recourse and nonrecourse debt.

In the opening example, if the investor's share of the mortgage and other partnership debt is $2 million, the amount realized is $3 million: $1 million of cash plus $2 million of debt relief. The investor never touches the $2 million, but the tax law treats it as if the buyer paid it on the seller's behalf.

Why a Negative Capital Account Signals a Large Gain

Your outside basis (your tax basis in the partnership interest) roughly equals your tax capital account plus your share of partnership liabilities. Depreciation deductions and cash distributions, especially distributions funded by refinancing, reduce your capital account. Over time it can drop below zero.

A negative tax capital account means you have already received more in deductions and distributions than you invested and earned. Since partnerships began reporting capital on the tax basis on Schedule K-1, that figure is easy to find. Continuing the example:

• Tax capital account: negative $1.2 million
• Share of partnership liabilities: $2 million
• Outside basis: $800,000
• Amount realized: $3 million ($1 million cash plus $2 million debt relief)
• Total gain: $2.2 million

Notice that the gain exceeds the cash by $1.2 million, which is exactly the negative capital account. That relationship is a useful sanity check whenever a client with a negative capital account asks what a sale will cost.

Not All of the Gain Is Taxed the Same Way

Under Section 741, gain on the sale of a partnership interest is generally capital gain. Several look-through rules carve out pieces that are taxed differently.

Section 751 "hot assets." Section 751(a) treats the portion of the sale price attributable to unrealized receivables and inventory as ordinary income. Unrealized receivables include depreciation recapture the partnership would recognize if it sold its assets, such as Section 1245 recapture on equipment, appliances, and the shorter-lived property often identified in a cost segregation study (see Treas. Reg. §1.751-1(c)(4)). The ordinary income piece can arise even when the overall sale produces a smaller gain or a loss.

Unrecaptured Section 1250 gain. Buildings placed in service after 1986 are depreciated on the straight-line method, so they generally produce little or no ordinary Section 1250 recapture. The gain attributable to that prior straight-line depreciation is instead "unrecaptured Section 1250 gain," taxed at a maximum federal rate of 25%. Under Treas. Reg. §1.1(h)-1(b)(3), a selling partner must look through to the partnership's Section 1250 property to determine this amount.

The remaining long-term capital gain is taxed at the regular capital gain rates, with a 20% top federal rate.

Suppose the $2.2 million gain in our example breaks down as $150,000 of Section 751 ordinary income from cost segregation property, $900,000 of unrecaptured Section 1250 gain, and $1.15 million of other long-term capital gain. At top federal rates, that is roughly $55,500 + $225,000 + $230,000, or about $510,000, before any net investment income tax and before state tax. On $1 million of cash, that is a meaningful bite.

Suspended Passive Losses May Finally Be Released

Many real estate investors carry suspended passive losses for years. Section 469(g) releases them when you dispose of your entire interest in the activity in a fully taxable transaction to an unrelated party. The losses are first allowed against income or gain from that activity, including gain on the sale, and any excess becomes deductible against nonpassive income.

Three cautions apply. The release generally requires a disposition of your entire interest, so selling half of a stake usually does not free the losses. A sale to a related party under Section 267(b) or 707(b)(1) does not trigger the release until the related buyer later sells to an unrelated person. And if you grouped this activity with others under Treas. Reg. §1.469-4, the "entire interest" test generally applies to the grouped activity, which can leave losses suspended unless you can show the part sold qualifies as a separate activity under Treas. Reg. §1.469-4(g).

The Buyer's Side: Section 754 and Section 743(b)

The buyer pays a price based on the fair market value of the building, but the partnership's inside basis in its assets does not automatically change. Without an adjustment, the buyer inherits the seller's low inside basis and the depreciation deductions that go with it.

If the partnership has a Section 754 election in effect, Section 743(b) adjusts the basis of partnership property for the buyer alone, generally stepping it up to reflect the purchase price. The step-up allocated to depreciable property can produce significant new deductions. Two points belong in the negotiation:

• Ask whether an election is in place. If not, the buyer will usually want the partnership to make one for the year of the sale. A buyer who will receive a step-up may be willing to pay more for the interest.
• A basis decrease can be mandatory. Under Section 743(d), when the partnership has a substantial built-in loss immediately after the transfer, the adjustment applies even with no Section 754 election. That occurs when the partnership's adjusted basis in its property exceeds the property's fair market value by more than $250,000, or when the buyer would be allocated a loss of more than $250,000 if the partnership sold all its assets for fair market value. In that case the buyer's share of inside basis is reduced.

Other Items to Review Before Closing

• Net investment income tax. Gain on a partnership interest can be subject to the 3.8% tax under Section 1411. Under Section 1411(c)(4), gain attributable to property of a trade or business that is not a passive activity for you may be excluded, which requires a look-through analysis.
• Withholding and paperwork. Section 1446(f) requires a buyer to withhold 10% of the amount realized, including the debt relief, when the seller is a foreign person. A U.S. seller normally provides a Form W-9 to avoid this. When the partnership holds Section 751 property, the seller must also notify the partnership of the sale under Section 6050K so it can file Form 8308.
• State tax. States may tax the gain where the seller lives, where the property sits, or both.
• Alternatives. A redemption by the partnership, a sale of the property followed by a Section 1031 exchange at the partnership level, or holding the interest until death (when the heirs may receive a basis step-up under Section 1014) can produce very different results. Each has its own requirements and trade-offs.

Key Takeaways

• Your share of partnership debt is added to the cash price to determine your amount realized under Section 752(d) and Treas. Reg. §1.752-1(h).
• A negative tax capital account means your gain will exceed the cash you receive, often by the full negative balance.
• Section 751 converts part of the gain to ordinary income, and unrecaptured Section 1250 gain on buildings is taxed at up to 25%.
• A taxable sale of your entire interest to an unrelated buyer generally releases suspended passive losses under Section 469(g).
• A Section 754 election benefits the buyer through a Section 743(b) step-up, and a substantial built-in loss requires an adjustment even without the election.

If you are considering selling a partnership interest, or a buyer has approached you, schedule a consultation with SMB CPA Group so we can model the gain, its character, and the cash you will keep before you commit. You can also contact us, learn about our custom scope of work for transaction planning, or review our pricing.

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