Partnership tax basis and long term investing

Tax, SDIRAs & Cost Segregation
6yFollow

Partnership tax basis and long term investing

Sam Dangremond
Investor · Pueblo, CO · Member since 2012 · 96 posts · 63 votes

I have a somewhat specific tax related question I'd like to see if anyone has encountered before.

(Standard disclaimers apply, you're not giving me tax advice or financial advice, just looking for general resources etc.)

Here's the scenario: a partnership owns one or more long term rental properties.  Each partner contributed say $100,000 to the partnership to purchase the rentals.  No leverage used.  So, each partner has a tax basis and capital account in the partnership of $100,000.  Then, each year the rentals give off more cash than profits because of depreciation - all normal stuff.

But here's what I don't understand: if the partners withdraw all the cashflow each year, then each of their tax basis will gradually go down (because they are withdrawing more in distributions than their share of the profits due to depreciation).  Eventually, the tax basis will hit zero won't it? And when that happens, apparently every additional dollar withdrawn is taxed at long term capital gains? 

Example:

Year 1 - partner's tax basis is $100k... annual partnership cashflow is $20k.... partner withdraws $10k in cash (half of the cash)... however the partner's yearly profits reported on K-1 are only say $5k... because the partner withdrew more in cash than his share of profits, his tax basis goes down by the other $5k.   Accordingly, after 20 years this partner will have a zero tax basis.... correct? Or no?

This means that eventually the cashflow itself is taxed as a gain, because the partner has "used up" all his tax basis?

Is my understanding correct?

If so, how does this interact with depreciation recapture, other long term capital gains, or anything else, at sale of the property or disposition of the partnership? 

Any guidance is much appreciated!

0Reply
44 views

Most Popular Reply

Michael PlaksPro Member
Tax Accountant / Enrolled Agent · Houston, TX · Member since 2014 · 5k+ posts · 6k+ votes
6y

@Sam Dangremond

Let me give it a shot, as I'm afraid the discussion missed some fundamentals.

1. Distributions come from income, and taxable income increases partners' capital account and basis.

Say partners contributed $100k each and ignore depreciation. The partnership made $20k of income, or $10k for each partner. They distributed every penny. 

Because of the $10k cash distribution, partners' capital accounts and bases dropped to $90k. However, because of the $10k taxable income, they are increased by $10k, bringing them right back to $100k. In other words, if you distribute all income, your basis and capital accounts do not change.

2. Now throw in deprecation.

Same scenario, except now we have $16k depreciation, or $8k per partner. We still distribute the entire $20k income, $10k per partner. But due to depreciation, taxable income is only $4k or $2k per partner.

Result: partners' $100k capital accounts and bases are reduced by $10k distribution and increased by $2k taxable income, ending up $92k. In other words, capital accounts and bases go down if we have distributions in excess of taxable income.

3. Hitting the floor.

Bases and capital accounts will continue to slide down as you continue to take depreciation and distribute the entire cash flow. However, your total depreciation cannot exceed the total cost of the property. And your total cost of the property, in the absence of leverage, cannot exceed your capital contributions.

Result: you can never hit the $0 floor this way.

4Reply
See this reply in the discussion

7 Replies

Jump to latestLatest
  • Adam Rasmussen
    Accountant · Vancouver, WA · Member since 2019 · 100 posts · 71 votes
    6y

    I believe you have a good grasp of the concept of basis. But I don't think you need to worry about the long term capital gain unless one partner is taking out more cash than the other. Reason why:

    Each partner's basis is equal to 50% of the cash in the bank account + cost basis of the rental (since there is no debt). Since you can't have a negative cash account or negative basis in the rental you will be fine. As I mentioned earlier, if one partner takes out $20k and the other takes out $2k, this is where individuals run into trouble because they are essentially taking the other partner's assets when they have no remaining basis in the partnership. 

    Hope that helps.



    3Reply
  • Sam Dangremond
    OP
    Investor · Pueblo, CO · Member since 2012 · 96 posts · 63 votes
    6y

    Thank you for replying!

    Yes, I think I understand what you mean about internal fairness between the two partners.

    However, there's still a long term capital gain on the cashflow in excess of profits once the basis is "used up" right? This tax means that the net after-tax cash flow to each partner/investor is reduced, even though there's no disposition of the rental property asset?

    0Reply
  • Eamonn McElroy
    Accountant · Atlanta, GA · Member since 2015 · 1k+ posts · 1k+ votes
    6y

    This tax means that the net after-tax cash flow to each partner/investor is reduced, even though there's no disposition of the rental property asset?

    No, that's not correct.  The gain is outside of the partnership.

    No gain or loss is recognized by the partnership in this situation.  If the cash would have stayed in the partnership, no gain would have been recognized by the partner either.

    What you're describing in a "distribution in excess of basis".  As Adam noted, this can only occur when distributions are done disproportionally.  And, with a partnership, there's no requirement that distributions must be proportionate (one of the reasons partnership can be a very attractive tax entity IMO), so it does happen from time to time.

    I think you're viewing this from the wrong angle.  Cash flow isn't taxed, neither actually nor effectively.  The tax is on the partner due to full recovery of tax basis in his/her partnership interest, and then some.  The "and then some" is what's taxable.

    3Reply
  • Sam Dangremond
    OP
    Investor · Pueblo, CO · Member since 2012 · 96 posts · 63 votes
    6y

    Aha, now we're talking - thank you for your thorough reply!

    Yes, I think I understand how the gain is outside the partnership. But doesn't *the partner* have to pay that tax nonetheless? When the partner takes out more cash once a zero basis is reached?

    You're saying no, if *both* have a zero basis at the same time?

    I guess my basic question is about how, over the long term, a rental property (or portfolio of multiple rental properties) can generate so much more cash flow than profits due to depreciation that the entire partnership basis is used up when that cash flow is withdrawn. 

    0Reply
  • Ashish AcharyaBusiness Member
    CPA, CFP®, PFS · FL · Member since 2017 · 5k+ posts · 3k+ votes
    6y
    Originally posted by @Sam Dangremond:

    Aha, now we're talking - thank you for your thorough reply!

    Yes, I think I understand how the gain is outside the partnership. But doesn't *the partner* have to pay that tax nonetheless? When the partner takes out more cash once a zero basis is reached?

    You're saying no, if *both* have a zero basis at the same time?

    I guess my basic question is about how, over the long term, a rental property (or portfolio of multiple rental properties) can generate so much more cash flow than profits due to depreciation that the entire partnership basis is used up when that cash flow is withdrawn. 

    As mentioned above by our knowledgeable colleagues, if allocation is 50/50, a partner cannot take more cash than what is earned by or contributed by the partner. You can’t take more cash than you have in the bank account. 

    You can take more debt to take more cash distribution, but debt gives you basis for distributions so it’s not taxable.(interest on the debt might not be deductible) 

    I think this is what you are asking. 

    [email protected]941-914-7779
    INVESTOR FRIENDLY CPA®5241 Reviews
    WebsiteView Page
    TaxMD™ | AI-Powered Tax Planning
    WebsiteView Page
    2Reply
  • Michael PlaksPro Member
    Tax Accountant / Enrolled Agent · Houston, TX · Member since 2014 · 5k+ posts · 6k+ votes
    6y

    @Sam Dangremond

    Let me give it a shot, as I'm afraid the discussion missed some fundamentals.

    1. Distributions come from income, and taxable income increases partners' capital account and basis.

    Say partners contributed $100k each and ignore depreciation. The partnership made $20k of income, or $10k for each partner. They distributed every penny. 

    Because of the $10k cash distribution, partners' capital accounts and bases dropped to $90k. However, because of the $10k taxable income, they are increased by $10k, bringing them right back to $100k. In other words, if you distribute all income, your basis and capital accounts do not change.

    2. Now throw in deprecation.

    Same scenario, except now we have $16k depreciation, or $8k per partner. We still distribute the entire $20k income, $10k per partner. But due to depreciation, taxable income is only $4k or $2k per partner.

    Result: partners' $100k capital accounts and bases are reduced by $10k distribution and increased by $2k taxable income, ending up $92k. In other words, capital accounts and bases go down if we have distributions in excess of taxable income.

    3. Hitting the floor.

    Bases and capital accounts will continue to slide down as you continue to take depreciation and distribute the entire cash flow. However, your total depreciation cannot exceed the total cost of the property. And your total cost of the property, in the absence of leverage, cannot exceed your capital contributions.

    Result: you can never hit the $0 floor this way.

    4Reply
  • Sam Dangremond
    OP
    Investor · Pueblo, CO · Member since 2012 · 96 posts · 63 votes
    6y
    Aha, thank you - now I get it!!

    Ok, I failed to tie the depreciation amount back to the purchase price made with the original capital contribution.  You can't ever get more depreciation than what you put in at the beginning.  

    Thank you to all who replied, I am extremely appreciative!
    0Reply
Join the conversationCreate a free account to reply, vote on answers and follow this thread.
Log InJoin for Free