An interest in a partnership is considered a capital asset. Loss upon sale of a partnership interest is therefore generally treated as a capital loss.
But can the sale of a partnership interest be restructured to permit ordinary losses? With inventive planning, it can – particularly for real estate and other “asset-rich” partnerships.
Rather than a having a partner sell his interest in the partnership to a third party, the partnership can make an “in-kind” liquidating distribution to the departing partner of an undivided interest in partnership property (such as real estate) commensurate with the value of that partner’s partnership interest.
The departing partner then is able to sell the undivided interest in the partnership property to the third party. Assuming that the partnership property (such as real estate) is considered a Section 1231 asset (property used in a trade or business), the capital loss can then effectively be converted into an ordinary loss.
An established, more sophisticated (and generally more practical) variation of this method entails having the partnership itself sell an interest in the partnership property to the purchaser equal in value to the departing partner’s interest. Rather than the departing partner selling the partnership interest to a third party, the partnership may sell an equivalent undivided interest in its assets (such as real estate) to the third party, taking a leaseback of the undivided interest.
Proceeds of the partnership’s sale are then distributed to the departing partner in liquidation of his interest, and the partnership’s ordinary loss on the sale can be directly allocated to the selling partner.
To secure ordinary loss treatment, certain precautionary structural measures are crucial to prevent application of the judicially-articulated anti-abuse “step transaction” and “substance over form” doctrines (also addressed under Section 707(a)(2)(B)), which could otherwise fuse or re-cast the transactions. Additionally, any special allocations of the ordinary loss must be made in a manner that complies with the requirements for “substantial economic effect” under Section 1.704-1(b)(2) of the Treasury Regulations.