Interaction of Loss Disallowance Rules of §707 and Substantial Built in Loss Rules of §743(d) Discussed in Three IRS Private Letter Rulings

In a series of private letter rulings (PLRs 201613001, 201613002 and 201613003) the IRS issued a ruling on how to handle a situation where both the related party loss rules of IRC §707(b)(1)(a) and the substantial built-in loss rules of §743(d) applied to a transaction.

The cases involved the sale of a partnership interest to a grantor trust by a partnership in a transaction that triggered a disallowed loss to the seller under the related party rules of IRC §707(b)(1)(a). 

Treas. Reg. § 1.707-1(b)(1)(ii) provides that if the taxpayer later sells the property at a gain, the same rules would apply as do under §267 (the general related party provision) when a loss is denied to seller.  Under IRC §267(d) provides that “then such gain shall be recognized only to the extent that it exceeds so much of such loss as is properly allocable to the property sold or otherwise disposed of by the taxpayer.” 

Note that the basis of the property isn’t actually increased in the hands of the acquirer—rather the acquirer simply doesn’t recognize gain on the sale of the property unless it exceeds the previously disallowed amount.  Despite the fact some of us may think of this as a “dual basis” asset (one basis for loss, another for gain), the reality is that there is still just one basis—the amount the buyer paid.

Normally the “dual basis” thinking works fine and it’s why we often simplify the situation with that sort of “rule” when dealing with these situations.  However the asset acquired in this situation was a partnership interest.  While the acquired partnership did not have in place an election under IRC §754 to adjust the basis of assets in such a situation, nor did it make such an election in this tax year, the partnership had a “substantial built-in loss” as defined in IRC §743(d).

A substantial built in loss exists when the “partnership’s adjusted basis in the partnership property exceeds by more than $250,000 the fair market value of such property.” [IRC §743(d)(1)]  In such a situation, despite the lack of an election under §754 that is normally required to trigger an adjustment of the basis of partnership assets with regard to the acquirer under §743, IRC §743(b) provides that the adjustment is still required to be made.

Since actual basis of the buyer is what was paid, with no effect given to the disallowed loss, the partnership is required to compute the downward adjustment for the assets it holds.  If the partnership later sells one of those assets at a gain, the partnership will compute and pass out to the buying partner an adjustment based on the basis difference for that partner’s portion of the asset.  Normally that partner would end up reporting a larger gain based on that adjustment.

The concern that brought forth the letter ruling request was whether, since the partnership interest itself (the asset subject to the loss disallowance) wasn’t being sold, would the buyers end up having to recognize that “extra” gain on their returns?  That is, will the buyers have to defer getting the use of that “buffer” until they actually dispose of the partnership interest itself?

The IRS, granting the ruling requested, determined the answer is no.  Rather the partner is allowed to reduce that “extra” basis adjustment on the sale of an asset by the partnership by the portion of the adjustment under §743 that was allocable to that particular asset.  Only once the gain exceeds that allocable amount would the buyer end up recognizing the gain.