Many investors are surprised to learn that claiming a loss from a partnership today can pave the way to a tax liability in a future year. It is a common scenario: an investor receives a Schedule K-1 reporting a tax loss, the loss is deducted on the investor’s individual income tax return and is used to offset other items of income thereby generating current tax savings. Years later, the partnership refinances debt, sells property, or repays loans, and now the investor faces taxable income despite receiving little, if any, cash.
How does that happen? The answer often lies in the tax treatment of partnership losses and liabilities.
Not All Partnership Losses Are Immediately Deductible
Losses incurred by the partnership and allocated to its investors are subject to several layers of limitations before they may be utilized in the current tax year. Before a partner can use a loss, they generally must pass three types of limitations:
- Basis Limitations – a partner must have sufficient tax basis in their partnership interest to deduct a loss. Basis can come from:
-
- Capital contributions
- Previously taxed income allocated to the partner
- Certain allocations of partnership debt
Basis may be reduced by:
-
- Distributions received from the partnership
- Partnership losses allocated to the partner
- Reduction in the allocation of partnership debt
If a partner lacks basis, losses are suspended until additional basis is created.
- At-Risk Limitations – even if basis exists, a partner may not utilize losses in excess of amounts that they are economically at-risk. Generally, a partner is considered at risk for previously taxed capital, and partnership liabilities that the partner has guaranteed, loaned directly to the partnership, or is otherwise subject to recourse against the partner. Certain debt that is secured by real estate may qualify for at-risk basis even though it is nonrecourse debt for the partners.
These rules were enacted to prevent taxpayers from using losses generated by investments in which they have limited economic risk of loss. Paying attention to the limitations under this provision becomes especially important when the partnership is a limited liability entity such as an LLC, LP, or LLP where limited partners are generally at-risk for only their capital investment.
- Passive Activity Loss Limitations – Many partnership investments, including real estate investments, are considered passive activities. Unless exceptions apply, losses from passive activities generally can only offset income from passive activities. A taxpayer may therefore have sufficient basis and be at-risk but still be unable to currently utilize the loss.
Partnership Losses Funded by Debt
Because basis in a partnership increases from an allocation of partnership liabilities, an investor may have substantially more tax basis than the amount of cash originally invested.
Consider this example:
-
- Investor contributes $100,000 to an LLC taxed as a partnership in exchange for a 50% interest.
- The LLC borrows $800,000.
- The investor is allocated $400,000 of the debt.
In this example, the partner’s basis is $500,000 ($100,000 capital contributed plus $400,000 of allocated debt). This additional basis allows partnership losses to be deducted, perhaps long before the investment produces positive cash flow. For many partnership investments, debt allocations are the reason losses are deductible in the early years.
The Hidden Tax Trap
The problem arises when the debt that created the basis eventually disappears. Debt may be paid down, refinanced, eliminated through the sale of assets, or converted to equity.
A decrease in a partner’s share of liabilities is considered a deemed distribution and reduces the partner’s basis in the partnership. If the deemed distribution exceeds the partner’s basis, a taxable gain can result, potentially catching investors off-guard.
A Simplified Example
In the earlier example, the investor contributed $100,000 to the LLC and was allocated $400,000 of partnership liabilities for an initial basis of $500,000. Over several years:
-
- The partnership allocates $300,000 of losses to the partner.
- The investor deducts the full $300,000.
- Remaining basis equals $200,000.
Years later, the partnership sells assets, and repays debt. The investor’s share of partnership liabilities decreases by $400,000. As a result:
-
- Tax basis of $200,000 is decreased by a $400,000 deemed distribution due to the reduction in allocated liabilities.
- Because the deemed distribution exceeds tax basis, the excess triggers a taxable gain of $200,000.
In this basic example, the investor finds themselves recognizing gain despite receiving very little cash in the transaction.
Negative Capital Accounts
Investors frequently see negative capital accounts on their Schedule K-1s. In many situations, a negative capital account is not necessarily incorrect. An investor may have a negative capital account but positive tax basis due to allocated liabilities. Capital accounts and tax basis are not the same thing and situations could exist that permit an investor to currently utilize a loss while showing a negative capital account balance.
Although a negative capital account may not be incorrect, it should prompt a discussion with a tax advisor regarding future tax exposure and liability allocations.
The Bottom Line
Partnerships can provide desirable tax benefits, including the ability to utilize losses that may not be available through other entity types, and can provide its partners the flexibility needed so the tax ramifications closely follow the economic arrangements.
Reach Out to Learn More
When investing in a partnership, partners should have an understanding of the rules regarding basis, liability allocations, and the impact of future debt reductions. Having discussions with a tax advisor familiar with partnership taxation can help an investor avoid unpleasant surprises and make informed decisions about their partnership investments. For tax planning assistance, reach out to the Tax Strategy Group at H2R CPA.
Share:
