Rev. Rul. 81-242

ISSUE

May gain be recognized to each partner when mortgaged property owned by a partnership is involuntarily converted even though the partnership elects to defer the recognition of gain under section 1033 of the Internal Revenue Code?

FACTS

P is a general partnership of five individuals. In 1969, P purchased a building for commercial use. Through depreciation and other adjustments and distributions, the bases of the partners' interests had been reduced below their share of liabilities.

In 1980, City Y, through appropriate proceedings, acquired by condemnation the building owned by P for 20x dollars. At the time of the condemnation, the mortgage debt owed by P was 15x dollars, and P's basis in the property was 10x dollars. The award made by City Y was used to pay off the mortgage debt.

P elected to replace the building within the meaning of section 1033(a)(2) of the Code and within the time prescribed by section 1033(a)(2)(B).

LAW AND ANALYSIS

Section 1033(a)(2) of the Code provides that if property is involuntarily converted into money by condemnation, then any gain shall be recognized. However, section 1033(a)(2)(A) provides that if replacement property is purchased (under circumstances that comply with the pertinent provisions of section 1033), then, at the election of the taxpayer, gain shall be recognized only to the extent that the amount realized on the conversion exceeds the cost of the replacement property.

Section 703(b) of the Code provides that any election affecting the computation of taxable income derived from a partnership must be made by the partnership.

Furthermore, Rev. Rul. 66-191, 1966-2 C.B. 300, holds that the election under section 1033 of the Code not to recognize gain from an involuntary conversion can be made only by the partnership and not by the partners individually.

Section 731(a)(1) of the Code provides that when there is a distribution by a partnership to a partner, gain shall not be recognized to that partner, except to the extent that any money distributed exceeds the adjusted basis of that partner's interest in the partnership immediately before the distribution.

Section 752(b) of the Code provides that any decrease in a partner's share of the liabilities of a partnership, or any decrease in a partner's individual liabilities by reason of the assumption by the partnership of the individual liabilities, shall be considered as a distribution of money to the partner by the partnership.

In this case, P realized 10x dollars of gain from the condemnation of its building. Because P elected to replace the condemned building within the meaning of section 1033(a)(2) of the Code and within the time prescribed by section 1033(a)(2)(B), P is not required to recognize the 10x dollars gain realized from the condemned building. The award by City Y was used to pay off the 15x dollars of liability on the condemned building, resulting in a decrease in each partner's share of the liability of P. Under section 752(b) of the Code, the decrease is treated as a distribution of money to each partner. Thus, under section 731(a)(1), gain is recognized to each partner to the extent that the deemed distribution to each partner exceeds the adjusted basis of each partner's interest in P immediately before the distribution.

The transaction described above is distinguishable from that considered in Rev. Rul. 79-205, 1979-2 C.B. 255. In that ruling, a partnership made nonliquidating distributions of property to its two equal partners. Because the properties in question were subject to liabilities, the distributions resulted in a decrease in the liabilities of the partnership (a deemed distribution to each partner under section 752(b)), and an increase in each partner's individual liabilities (a deemed contribution by each partner under section 752(a)). The ruling concludes that the distributions were part of a single transaction and that the properties were treated as having been distributed simultaneously to the two partners. Thus, the resulting liability adjustments were treated as having occurred simultaneously.

In this case, the condemnation of the building and the subsequent reinvestment of the proceeds were separate transactions that did not occur simultaneously. When P subsequently acquired replacement property that was subject to a liability, each partner's share of the liability of P increased. Because this increase resulted from a separate transaction, it may not be netted against the decrease in liability on the prior condemnation of the original property. Therefore, the full amount of the decrease in liability was a deemed distribution of money to the partners.

HOLDING

Under section 1033 of the Code, the 10x dollars of gain from the condemnation of P's building is not recognized in 1980. However, under section 731(a)(1), gain is recognized to each partner to the extent that that partner's proportionate share of the deemed distribution of the 15x dollars of liability exceeds the adjusted basis of that partner's interest in P immediately before the distribution.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 79-205 is distinguished.