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The total loss you will be able to recognize for the two years is $80,000 unless you have been called upon to pay business debts. If that has happened it will increase your ability to recognize losses. The essential item here is that your loss is limited to your basis, in this case $80,000. Here is some material from the IRS partnership audit guide to help you see this.
A partner's ability to deduct partnership losses are subject to three sets of limitations, which are applied in the following order:
- Under IRC section 704(d), the loss must not exceed the amount of the partner's basis in the partnership interest;
- The loss is subject to the at-risk rules of IRC section 465;
- The loss is subject to the passive activity rules of IRC section 469.
Losses that do not meet the requirements for any of the three limitations are suspended at that level. Each of the three limitations provides for a carryover of any disallowed loss. Therefore, the three limitations address matters of timing rather than true disallowance.
In addition to the above loss limitations, IRC section 707(b) limits loss recognition on certain sales of property between "persons" and controlled partnerships or between two commonly controlled partnerships.
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ISSUE: BASIS LIMITATIONS
A partner's distributive share of partnership loss will be allowed only to the extent of the partner's adjusted basis in his partnership interest. This is calculated at the end of the partnership taxable year in which the loss occurs. The partner's outside basis is not allowed to fall below zero. The IRC section 704(d) limitation of losses must be met before at-risk and passive limitations apply. Thus, for example, if the partner has insufficient basis, losses are suspended and should not be reflected on either Form 6198 for the at-risk limitation or on Form 8582 for the passive loss limitations. See IRC section 705(a)(2) and IRC section 733.
A partnership may have several types of income, gain, loss, or deductions. If there are losses in all categories, and the IRC section 704(d) limitation applies, then each category of loss is limited in the proportion it bears to total losses, including disallowed losses from prior years. See Treas. Reg. section 1.704-1(d)(4) example (3).
Revenue Ruling 66-94 states that before applying the IRC section 704(d) limitation, the adjusted basis of a partner's interest is first reduced by withdrawals. This treatment favors the potential for treating distributions as tax-free and also permits the partners a measure of control in timing the use of a distributive share of partnership loss. A partner could, for example, trigger the use of a suspended loss in a high income year by making a capital contribution to the partnership. Alternatively, basis could also be increased by having the partnership borrow money. See Treas. Reg. section 1.704-1(d)(4) example 2.
If a partner with suspended IRC section 704(d) losses sells his/her entire partnership interest at a gain, the losses may not be utilized. This is true even if the gain exceeds the losses that have been carried over. In effect, losses suspended due to the IRC section 704(d) limitation remain at the partnership level.
- If there is little difference between book and tax (check M-1), a quick method to verify that the taxpayer has sufficient outside basis is to add the ending capital account on the K-1 and the nonrecourse and recourse amounts from the K-1. If there is a negative capital account at year-end and the capital account is still negative after netting out recourse and nonrecourse liabilities, the taxpayer does not have basis for his losses. This method will not work if the capital account reflects assets at fair market value.
- If there are large K-1 losses or if there are significant distributions, issue an IDR and ask the taxpayer to provide his outside basis computations.
- Determine whether the partner has sufficient basis to deduct K-1 line 1 trade or business losses or line 2 rental real estate losses If not, losses are suspended indefinitely until his basis is increased.
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Scrutinize the K-1s for significant losses on K-1 line 1 (trade or business), line 2 (rental real estate), or line 3 (other rentals).
Scrutinize the K-1s for distributions (line 19 for 2004 and later years).
Request the partner's related returns to review losses actually taken on the returns. If losses are in the nonpassive column on the back of Schedule E, that means they have been deducted in full. If losses are in the passive column on the back of Schedule E and on Form 8582, that means they have been subjected to the passive loss limitations.
Review K-1s for negative ending capital accounts. For 2004 and later years, the capital account analysis is in box N of the K-1. Reminder: A negative capital account may be of greater concern if the partnership is filing a final year return.
Documents to Request
- Prior and subsequent year partnership returns;
- Copies of partners' returns;
- Outside basis computation for partners with large losses;
- Suspended loss computation;
- Partnership agreement;
- Loan documents, guarantees.
- Were there cash or property distributions to any of the partners during the year?
- How many years has the partnership operated with losses?
IRC, Subchapter K:
Supporting regulation and specific regulations cited above.
Kingbay v. Commissioner 46 T.C. 147 - Partner's basis in the current year was determined to be zero because of the distributive share of the partnership losses. The Court held that deductions of partnership losses by limited partners are allowed only to the extent of the adjusted bases of their interests in the partnership at the end of the partnership year in which a loss occurred.
Revenue Ruling 66-94, 1966-1 C.B. 166 - Distributions are taken into consideration before losses in computing a partner's adjusted basis in the partnership interest under IRC section 704(a).
Sennett v. Commissioner 80 TC 825, aff'd per curiam, 752 F2d 428 (9th Cir. 1985) - A partner's suspended deductions under IRC section 704(d) expire upon the sale of his partnership interest.
RIA U.S. Tax Reporter - Income Taxes
CCH Standard Federal Tax Reporter
Practitioners Publishing Co.