Step Up: How to Avoid Negative Capital Accounts on Limited Partnership Interests Following the Death of the Partner

“In this world nothing can be said to be certain, except death and taxes,” quoth Benjamin Franklin. In this blog entry we are going to look at the intersection of the two, specifically in reference to how the death of a limited partner offers a one-time opportunity to revalue a limited partnership interest and thus to potentially eliminate a negative capital account on the holding.

In the context of personal finance, one’s capital account is simply an equity account in the accounting records of a partnership. In essence, it is the total one reaches when tabulating the initial contributions by a partner to a partnership, the profits and losses of the partnership allocated to the partner in accordance with the terms of the partnership agreement, and any and all distributions to the made to the partner (for more specific information on capital accounts from an accounting perspective, sites like accountingtools.com, which house a wealth of information on the topic, are good resources). When reviewing the Schedule K-1 forms of limited partnership interests, specifically those in affordable housing partnerships from the 1970s and early 1980s, we frequently find interests sidled with large negative capital accounts. This feature, so common in aging real estate partnership interests, is more often than not responsible for the difficulty many limited partners have in selling their interests. Through years of working around large negative capital accounts to bring about the liquidation of problem interests, LP Equity has come across several methods by which a negative capital account can be addressed, the wholesale most effective being to perform a date of death valuation on a limited partner interest upon the passing of the partner, or to step-up in basis.

 

SCENARIO No. 1 – INDIVIDUAL OWNERSHIP of PARTNERSHIP INTEREST

Let’s say Hugh Man, a theoretical limited partner investor, bought into an affordable housing partnership in 1976 for 1.6% as a way of sheltering otherwise taxable income. For decades this interest served its purpose, but come 2015, the capital account has been calculated to be -$100K (note: this is not abnormally high, we frequently see interests’ capital accounts exceeding this amount). Hugh is still living, and decides to try and sell this interest to simplify his portfolio, LP Equity agreeing to theoretically buy it for $1. Despite the fact that the interest has, for all intents and purposes, been given away, Hugh in this scenario would have to forfeit to the IRS a capital gains tax on the $100K, which might total $25K or thereabouts.

Hugh looks at the numbers and decides selling isn’t an option, and holds onto the interest until he passes. It’s now 2017, and Hugh’s daughter Woe, who is now in control of his estate, comes across this interest and again tries to sell, but sees the same unsolvable problem with the large negative capital account and despairs. Thankfully for Woe, there is a provision in the US tax code called a step-up in basis wherein, for a period upon the passing of a partner, his or her interest can be revalued based on the current market. Woe and her tax advisor take advantage of this opportunity and revalue the interest at $0 (note: also not unusual) and make the pre-arranged sale to LP Equity for $1. Woe will now owe the IRS a capital gains tax on only $1. These numbers do not represent a typical acquisition, however in their simplicity they demonstrate the mechanics at play in the context of liquidating an aging limited partnership interest. Although LP Equity is not certified to advise in an official capacity on issues surrounding taxation, having years of experience in this market has given us a clarity in thinking that may be useful to any limited partner looking to analyze, value, or sell his or her interest, or to perform a step-up in basis.

 

SCENARIO No. 2 – JOINT OWNERSHIP of PARTNERSHIP INTEREST

We’ve seen how things turned out for Hugh when he was the sole owner of the limited partnership interest, but let’s say for argument’s sake that Hugh and his wife, Belle, were joint tenants in common in the interest, or more simply that they co-owned the investment. If 2017 comes and Hugh passes, there having been no change to the ownership of the interest, the best-case-scenario Belle could hope for would be a half step-up in basis, wherein half of the value of the limited partnership interest could be revalued, half remaining the same. Using the numbers from before (-$100K capital account, $1 sale to LP Equity) and including a half step-up in basis revaluation of $0, Belle would still owe the IRS a capital gains tax on $50K, or roughly $12K. Thus it is that we sometimes recommend to clients, our non-accredited status notwithstanding, that given a joint owners failing health, they transfer ownership solely to the unwell owner so that, given a death, the interest can undergo a full step-up in basis, allowing for a complete revaluing. For more information please feel free to cont

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