IRS rules on when gain may be reduced by a previously disallowed loss

In a series of private letter rulings (PLR 201613001, PLR 201613002, and PLR 201613003), the IRS concluded that the sale of partnership property at a gain may be reduced by the amount of previously disallowed loss (pursuant to Sections 707(b)(1) and 267(d)) that originated from the sale of a partnership interest between related parties.

In the PLRs, D, a partnership for U.S. federal income tax purposes, held a partnership interest in both Fund 1 and Fund 2 (the Funds), both of which were partnerships for U.S. federal income tax purposes. D sold its partnership interests in the Funds to grantor trusts X, Y and Z. D recognized a capital loss that was partially disallowed pursuant to Section 707(b)(1).

At the time of the sale, the Funds did not have a Section 754 election in effect (nor did the Funds make such an election). However, the Funds had a substantial built-in loss (as defined in Section 743(d)), and the basis of the assets of the Funds were adjusted downward pursuant to Sections 743(b), (d) and 755. After the sale, the Funds recognized gains on the disposition of assets that the Funds held at the time of the sale. A ruling was requested on when a partner is entitled to reduce all or a portion of the gain allocated to it on the sale of assets by the previously disallowed loss.

Section 707(b)(1) disallows losses from the sale or exchange of property (other than an interest in a partnership) between a partnership and a person owning, directly or indirectly, more than 50% of the interests in profits or capital, or two partnerships in which the same persons own, directly or indirectly, more than 50% of the capital or profits interests. Section 707(b)(1) also provides that in the case of a subsequent sale or exchange between a partner and a partnership or two related partnerships as described above, Section 267(d) is applicable as if the loss were disallowed under Section 267(a)(1). Section 267(a)(1) provides that no deduction shall be allowed in respect to any loss from the sale or exchange for property, directly or indirectly, between certain related parties. Under Section 267(d), if a taxpayer subsequently sells or otherwise disposes of property that was previously disallowed under Section 267(a)(1) at a gain, then such gain is recognized only to the extent that it exceeds so much of the loss as is properly allocable to the property sold or otherwise disposed of by the taxpayer.

The IRS held that pursuant to Sections 707(b)(1) and 267(d), upon the sale by the Funds of property that was the subject of a downward basis adjustment (pursuant to section 743(b) and (d) with respect to the transferee partner), the transferee partner will recognize gain only to the extent that it exceeds the amount of disallowed loss properly allocable to the property sold or otherwise disposed of by the Funds.

In the PLRs, the IRS seemingly applied aggregate principles in arriving at its conclusion. The asset sale that originally gave rise to the disallowed related party loss was a partnership interest, but the gain to which Section 267(d) applied was with respect to assets of the partnership held at the time of the original loss transaction, rather than the partnership interest itself. Although there was no elaboration as to why the IRS permitted Section 267(d) to be applied with respect to property that was not exactly the same as the original property that gave rise to the disallowed loss,  the PLRs do seem to provide partners with the opportunity to use disallowed related party losses that originate from the sale of a partnership interest to offset subsequent gains that arise from the disposition of partnership property that the partnership held at the time of the original sale (rather than wait until the partnership interest itself is subsequently sold at a gain). However, careful consideration would need to be given in determining the amount of the disallowed loss that is properly allocable to the property later sold by the partnership.

Contact Grace Kim
Principal, Washington National Tax Office
+1 202 521 1590

Josh Carrasco
Sr. Associate, Strategy & Performance Improvement
+1 832 476 3616

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