Rev. Rul. 77-402

Advice has been requested whether, under the circumstances described below, gain or loss on the sale or exchange of a partnership interest is recognized under section 741 of the Internal Revenue Code of 1954.

A, an individual, created T, an irrevocable trust. A and B (A's spouse) are the trustees. All trust income is currently distributable for life to C, A and B's child. At C's death, the corpus is distributable to D, A and B's grandchild. A has expressly retained certain powers of the kind described in subpart E of part I of subchapter J of the Code. Therefore, for Federal income tax purposes, T is a "grantor trust" and A is considered the owner of the entire trust.

A, as the trustee, then used the funds that A, as grantor, initially contributed to T, to purchase on behalf of the trust an interest in P, a partnership. The principal activity of P is investing in real property, and P uses both recourse and nonrecourse financing. P properly elected to deduct accelerated depreciation, which generated large operating losses that P's partners were entitled to deduct on their income tax returns. A, as owner of T, deducted the distributive share of partnership losses attributable to the partnership interest held by T.

When the adjusted basis of the partnership interest held by T had been reduced nearly to zero, and just before the so-called "cross-over point" (when P no longer generated losses but began generating income), A, as grantor, renounced the powers previously and expressly retained that initially resulted in T being classified as a grantor trust. Consequently, T ceased to be a grantor trust and A was no longer considered to be the owner of the trust. Thereafter, C, as life beneficiary, was subject to tax on the income generated by the trust.

Section 671 of the Code provides, where it is specified in sections 673 through 679 that a grantor or another person shall be treated as the owner of any portion of a trust, that there shall be included in computing the taxable income and credits of the grantor or other person, the items of income, deductions, and credits of the trust attributable to the portion of the trust considered owned by such grantor or other person to the extent such items would be taken into account in computing the taxable income or credits of an individual.

Section 741 of the Code provides that in the case of a sale or exchange of an interest in a partnership, gain or loss shall be recognized to the transferor partner.

Section 752(d) of the Code provides that in the case of a sale or exchange of an interest in a partnership, liabilities shall be treated in the same manner as liabilities in connection with the sale or exchange of property not associated with partnerships.

In the instant case, since A was the owner of the entire trust, A was considered the owner of all the trust property for Federal income tax purposes, including the partnership interest, Since A was considered to be the owner of the partnership interest, A, not T, was considered to be the partner in P during the time T was a "grantor trust" under subpart E of part I of subchapter J of the Code.

However, at the time A renounced the powers that gave rise to T's classification as a grantor trust, T no longer qualified as a grantor trust, with the result that A was no longer considered to be the owner of the trust and trust property for Federal income tax purposes. Consequently, at that time, A is considered to have transferred ownership of the interest in P to T, now a separate taxable entity, independent of its grantor, A.

When a transfer of an interest in a partnership occurs and the transferor's share of partnership liabilities is reduced or eliminated, the transferor is treated as having sold the partnership interest for an amount equal to the share of liabilities reduced or eliminated. Under section 752(d) of the Code, the amount realized by the transferor A includes the reduction in or elimination of such liabilities. See Rev. Rul. 74-40, 1974-1 C.B. 159; Rev. Rul. 75-194, 1975-1 C.B. 80; and Johnson v. Commissioner, 495 F.2d 1079 (6th Cir. 1974), aff'g 59 T.C. 791 (1973), cert. denied, 419 U.S. 1040 (1975). Any gain or loss realized on a sale or exchange of a partnership interest is recognized pursuant to section 741 of the Code.

Accordingly, in the instant case, A realized an amount equal to the share of partnership liabilities that existed immediately before T converted from grantor to nongrantor status for Federal income tax purposes. The gain or loss realized by A is the difference between the amount realized from the reduction of the share of P's liabilities and the adjusted basis in the partnership interest under section 705 of the Code immediately prior to the change in T's tax status. The gain or loss so realized must be recognized by A under section 741.

Furthermore, the result would be the same if the trust ceases to be a grantor trust by reason of the expiration or lapse of the powers. The result would also be the same if the trust were treated as a grantor trust by reason of powers exercisable by a party other than the grantor and ceased to be a grantor trust upon the release or renunciation of those powers by such other party or upon the expiration or lapse of such powers.