Q: I acquired a 10% interest in a real estate partnership in 2018. The partnership is a Delaware entity and the property is in New Mexico. I have contributed $118,000 to date. The property appears to be undevelopable and the manager is asking (again) for a capital call. I am unwilling to put more money into this venture. The manager has informed me that, based on the operating agreement, I will forfeit my interest if I fail to make the capital call. No one can tell me the tax effect of a forfeiture of my interest in this situation. I have had a few conversations with an attorney because I may consider a lawsuit against the manager for breach of fiduciary duty and possibly also for the seizure of my interest. But he is not a tax attorney and has not provided any tax consequences to me.
A: The best I can do is provide a high-level analysis. This is so because the potential actions that you suggest can affect the tax consequences.
As a general rule, if you were to forfeit a partnership interest due to a failure to make a capital call and, pursuant to a provision in the agreement, I would consider it to be an abandonment of the interest.
The tx treatment of an abandonment is fairly clear. However, an abandonment requires an affirmative action. So, for example, if failure to make the capital call includes some formal notice by you that affirms the forfeiture of the interest, you should have an abandonment.
You have not said whether this partnership has borrowed money and, if so, whether you have been allocated a share of this debt for partnership tax purposes.
You should check any K-1 forms provided to you for prior years. If there is debt that was allocated to you, it will show up on the K-1 form.
You also did not indicate whether you have claimed any deductions for any portion of your $118,000 investment. I will assume ‘no’ just to explain the consequences.
If you still have an unrecovered $118,000 investment, you will have a $118,000 loss from abandonment. This will be so whether or not you are allocated a share of entity debt.
If there is no partnership debt, or no debt allocated to you on the K-1 form, your loss may be an ordinary loss under Section 165 of the tax law.
If there is any debt allocated to you, any loss will be a capital loss. This is so because the relief of debt that should occur when you forfeit the interest will be treated as sales consideration.
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For example, assume that $100,000 of debt is shown on your K-1 form. First, this increases your tax basis for the interest from $118,000 to $218,000.
The forfeiture will treat the debt relief as sales consideration. You will have $100,000 deemed received and that creates a $118,000 loss based on the $218,000 basis (which includes the debt).
Because you are deemed to have received sales consideration, the forfeiture of the interest will be treated as coming from the sale of a capital asset and will then be a capital loss.
The capital loss is a bad result. Capital losses can only offset capital gains or otherwise be deducted at a maximum of $3,000 per year.
If there is no debt allocated to you, the forfeiture will not result in any deemed sales consideration. This creates an ordinary tax loss due to the failure to have a “sale.”
My answer to you must be hedged by your statement that you might sue the managing member. If you seek to invalidate the forfeiture, then you are clearly not taking any affirmative action to abandon the interest.
I do not believe that you can claim any current tax loss, whether ordinary or capital, if you do not take an affirmative step to abandon the interest.
Your plans for legal action would then delay any tax benefit from a loss. I realize that you said you are just considering this action.
However, as you consider further action, you certainly would not sign any document that confirms that you abandon rights to your interest.
James R. Hamill is the director of tax practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at [email protected].
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