SECTION 1014 AND UNDERSTANDING THE TAX NATURE OF CERTAIN ASSETS – Part III C
“Negative Basis” Assets and “Negative Capital Account” Partnership Interests
“Negative basis” is the colloquial phrase used to describe a situation where the liabilities in a partnership (as also shared by the partners) are in excess of the tax basis of the partnership assets (and in the basis of the partners’ interests in the partnership). Note, the basis of an asset may not go below zero, so the phrase “negative basis” is technically incorrect. Even successful real property investment partnerships may have negative basis assets where the underlying developed real property has been fully depreciated and cash from refinancings has been distributed to the partners.
The following example illustrates how this “negative basis” problem can arise and how costly a taxable event would be from an income tax standpoint:
(1) Taxpayer bought an office building in 1983 for $10,000,000 (assume for purposes of this example, the entire purchase price is properly allocated to the office building, which is depreciable). Over the next 30 years, the property appreciated in value, the taxpayer fully depreciated the original basis of $10 million in the building to zero, borrowed against the property, and took the loaned funds tax free. In 2013, the office building is worth $20 million, has zero adjusted tax basis, and there is a mortgage on the building of $15 million leaving $5 million of net equity in the property.
(2) Because the property was placed in service in 1983, an accelerated method of depreciation was allowable on the property. Thus, a taxable sale of the property will be subject to recapture under the Code and because the property was placed in service prior to 1986, the recapture is under section 1245 (rather than section 1250 which generally applies to real property). As such, the total amount of the depreciation deductions is subject to recapture as ordinary income.
(3) If the building is sold for $20 million in a taxable transaction, the gain would break down as follows:
Amount Recognized: $20,000,000
Adjusted Basis: $ –
Recapture: $10,000,000 ordinary income
Long-Term Capital Gain: $10,000,000 long-term capital gain
Assuming the taxpayer is in the highest income tax bracket and in a relatively high income tax state, like a New York City taxpayer, the ordinary rate would be approximately 45% and the long-term capital gain rate would be approximately 37%. The total tax liability would be $8.2 million. After repayment of the $15 million of debt, the taxpayer (who would net $5 million in cash from the transaction before taxes) would actually be in deficit by approximately -$3.2 million after the payment of income taxes.
(4) Compare the result if the taxpayer died owning the building. The building would get a “step-up” in basis under section 1014(a) of the Code to fair market value, the recapture and long-term capital gain tax problem would be eliminated. If the taxpayer has $5.25 million of Applicable Exclusion available, the maximum estate tax liability (assuming a top state death tax rate of 16%) would be approximately $7.3 million (maximum blended rate of 49.6%). If the Applicable Exclusion Amount grows to $8 million, for example, then the estate tax liability would drop to approximately $6.0 million. If the foregoing building were in California, the income tax liability would be greater, and the estate tax cost would be even less because California does not have a death tax. With an Applicable Exclusion Amount of $5.25, the estate tax liability is approximately $5.9 million.
(5) Property placed in service after 1986 will not have as an extreme an income tax problem because the gain would not have recapture calculated under section 1245 of the Code. Rather, section 1250 would be the applicable recapture provision. “Section 1250 property” means any real property, with certain exceptions that are not applicable, that is or has been property of a character subject to the allowance for depreciation. Section 1250(a)(1)(A) provides that if section 1250 property is disposed of, the “applicable percentage” of the lower of the “additional depreciation” in respect of the property or the gain realized with respect to the disposition of the property shall be treated as ordinary income. In short, section 1250 provides that all or part of any depreciation deduction in excess of straight-line depreciation is recaptured as ordinary income.  Under the current depreciation system, straight-line deprecation is required for all residential rental and nonresidential real property. As such, section 1250 recapture is typically not a problem for property placed in service after 1986. The Code does, however, tax “unrecaptured section 1250 gain” at a 25% tax rate. Unrecaptured section 1250 gain is essentially the lesser of all depreciation on the property or the net gain realized (after certain losses) to the extent not treated as ordinary income under section 1250 of the Code.
(6) From an estate planning perspective, it is important to remember that even if recapture is inherent in an appreciated property, it does not apply to a disposition by gift or to a transfer at death, unless the recapture would be considered income in respect of a decedent.
Today, most real property investments are not held individually, but are held typically in an entity taxable as a partnership (for example, a limited liability company or limited partnership). When real property investments are the subject to refinancing followed by a distribution of the loan proceeds, the partnership debt rules under section 752 of the Code must be considered when determining the income tax cost of selling such property. Any increase in a partner’s share of partnership liabilities (whether recourse or nonrecourse to such partner) is treated as a contribution of money by the partner to the partnership, resulting in an increase in the partner’s basis in his or her partnership interest (“outside basis”). Any decrease in a partner’s share of partnership liabilities is treated as a distribution of money by the partnership to the partner, resulting in a decrease in the partner’s outside basis. A partner’s outside basis may not be reduced below zero, so a deemed distribution of money that arises from a decrease in a partner’s share of liabilities will give rise to gain recognition.
In the example described above, consider if a partnership owned a fully depreciated $20 million building. The partnership has $15 million of debt which is in excess of the basis in the building and in excess of the taxpayer’s outside basis. Assume for this example that we can ignore other partners because they have relatively insubstantial interests in the partnership. When a partner has a negative capital account, so that the outside basis is less that the partner’s share of partnership liabilities, it is also colloquially called “negative basis.” A transfer by the taxpayer, whether a taxable sale or a gift to a non-grantor trust, creates what is often referred to as “phantom gain” because the transferee takes over the transferor partner’s negative capital account. A partner who sells a partnership interest must include in income his or her allocable share of the partnership’s recapture from depreciated partnership property. The transfer results in a decrease in the transferor partner’s share of liabilities, which in turn is treated as a distribution of money to the partner when the partner has an outside basis of zero, resulting in gain in a donative transfer or additional gain in the case of taxable sale.
When dealing with highly appreciated, depreciable assets like real property and partnership debt, taxable sales of the property and inter-vivos transfers of partnership interests can be problematic. In many cases, given reduced transfer tax rates and growing Applicable Exclusion Amounts, it will make more economic sense to die owning these assets than to transfer them during the partners’s lifetime. The transfer of a partner’s interest on death is a disposition that does not result in gain or loss recognition, even if the liability share exceeds outside basis. The outside basis of the decedent receives a “step-up” in basis to fair market value (net of liabilities) but is also increased by the estate’s share of partnership liabilities. Further, if the partnership makes an election under section 754 of the Code, the underlying assets in the partnership will also receive a “step-up” in basis. Even if a section 754 election is not made, the estate or the successor beneficiaries of the partnership interest can get the benefit of a “step-up” in the underlying assets if the successor partner makes an election under section 732(d) of the Code and if the partnership distributes the assets for which there would have been a basis adjustment. Note, the election must be made in the year of the distribution if the property is depreciable, depletable or amortizable.
 §§ 1016(a)(2), 168(a), and Treas. Reg. § 1.1016-3(a)(1)(i).
 Accelerated Cost Recovery System (“ACRS”) was enacted in 1981 under the Economic Recovery Tax Act of 1982 (“ERTA”), P.L. 97-34. ACRS was later modified by the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”), P.L. 97-248, and the Tax Reform Act of 1984, P.L. 98-369, when the recovery period for most real property was extended from 15 to 18 years. In 1985, the real property recover period was extended from 18 to 19 years, P.L. 99-121, § 103. ACRS generally applies to property placed in service after December 31, 1980, and before December 31, 1986. Prop. Reg. § 1.168-4(a). The Tax Reform Act of 1986, P.L. 99-514, (“TRA 1986”) dramatically changed the applicability of ACRS to real property investments and instituted the modified ACRS (“MACRS”). Notably, the “applicable recovery period” for most real property assets like buildings are placed in 27.5 or 39-year recovery periods, while land improvements fall within 15 or 20-year recovery periods. § 168(c). In this example, because it was placed in service before 1984, the building would be considered 15-year real property, pursuant to which the applicable percentage of depreciation was 12% in the first year, reducing to 5% in from 11 to 15 years.
 § 1245(a)(5) before being amended by TRA 1986, defines “§1245 recovery property” to include all recovery property under ACRS, real or personal, other than certain types of 19-year (18-year for property placed in service after March 15, 1984, and before May 9, 1985; and 15-year for property placed in service before March 16, 1984) real property and low-income housing: residential rental property, property used “predominantly” outside the United States, property as to which an election to use straight-line recovery is in effect, and certain low-income and Federally insured residential property. The foregoing types of property are subject to recapture under section 1250 of the Code. In this example, the office building does not fall within the listed categories, and as such is subject to recapture under section 1245 of the Code.
 See § 1245(a)(2).
 § 1245(a)(3).
 § 1250(c).
 § 1250(b)(1), (3), (5).
 § 168(b)(3)(A)-(B).
 § 1(h)(6).
 § 1250(d)(1) and (2).
 §§ 752(a) and 722. Treas. Reg. § 1.752-1(b).
 §§ 752(b) and 733. Treas. Reg. § 1.752-1(c).
 § 731(a) or 751.
 As discussed, this is a misnomer because basis can never go below zero. Partnership borrowings and payments of liabilities do not affect the capital accounts, because the asset and liability changes offset each other. See Treas. Reg. § 1.704-1(b)(2)(iv)(c).
 §§ 751 and 453(i)(2). Under § 751, unrealized receivables are deemed to include recapture property, but only to the extent the unrealized gain is ordinary income. Treas. Reg. § 1.751-1(e) and (g).
 Rev. Rul. 84-53, 1984-1 C.B. 159, Situation 4.
 See Steve Breitstone and Jerome M. Hesch, Income Tax Planning and Estate Planning for Negative Capital Accounts: The Entity Freeze Solution, 53 Tax Mgmt. Memo. 311 (08/13/12).
 See Manning and Hesch, Sale or Exchange of Business Assets: Economic Performance, Contingent Liabilities and Nonrecourse Liabilities (Part Four), 11 Tax Mgmt. Real Est. J. 263, 272 (1995), and del Cotto and Joyce, Inherited Excess Mortgage Property: Death and the Inherited Tax Shelter, 34 Tax L. Rev. 569 (1979).
 §§ 1014(a), 1014(b), 742; Treas. Reg. §§ 1.1014-1(a), (b), and 1.742-1. The election is made by the distributee partner’s attaching a schedule to the income tax return setting out (i) the election to adjust the basis of distributed property under section 732(d) of the Code, and (ii) the computation of the basis adjustment to the distributed properties. Treas. Reg. § 1.732-1(d)(3). The election must be made in the year of the distribution if includes depreciable, depletable or amortizable property, but if
 § 743(a).
 § 732(d) and Treas. Reg. §1.732-1(d)(1)(i)-(iii).
 If the property is not depreciable, depletable or amortizable not, the election can be made up until the first year in which basis has tax significance. Treas. Reg. § 1.732-1(d)(2).