Colorado Real Estate Journal - December 17, 2014

Abandonment issues may work in year-end tax planning

When I review the tax returns of individuals who are active investors in real estate partnerships, it is not unusual to find investments that have been held for quite some time, well past the intended investment life.

This is often an indicator that they have a “burnt-out” real estate investment; an investment that is limping along but really doesn’t have much prospect of recovery. It runs counter to most investors to consider abandoning an asset, but with burnt-out partnership interests, it might be the only way to recoup at least some of the investment in the form of tax losses. I will speak first to an issue I see often in the real estate context and then briefly cover other situations that could be equally beneficial.

If you have a real estate investment in which you are passive – either as a limited investor or an investor in for-rent real estate – where the investment has, shall we say, “not gone well,” you likely have the following scenario.

You have received K-1s year after year with substantial losses, which you can’t use because they are passive to you and therefore are suspended for tax purposes until you have passive income to offset or you dispose of the asset. As a limited investor, your options are often “limited” as well if the asset has marginal or no value (assets worth less than the debt against the property). There are no buyers for your interest and the sponsor of the deal will keep the partnership going as long as possible. This allows them to continue to collect fees and hope against hope that market forces will bail them out.

However, they likely can use the passive losses to offset that management fee income and may be faced with phantom income if they sell the asset.

The lender is predisposed to pretend and extend (the loan) to avoid having to take the property and deal with it on their own time and dime. A less than ideal but potentially practical solution for the investor who is out of the decision-making loop and can’t force a disposition is to abandon the asset (the partnership interest in this case).

An abandonment of a partnership interest is as straightforward as notifying the partnership that you have concluded the interest has no value and you have chosen to relinquish the partnership interest.

Obviously, you would not take this step unless you believe that statement to be true. The tax result will be to free up the suspended passive losses, making them available to you to offset ordinary income (the holy grail of tax planning). If you have held the investment for some time, you will likely benefit by some of those losses offset not by your cash investment, but by capital gain, benefiting further from the tax rate arbitrage inherent in that result (capital gain offset by ordinary loss in equal amount).

This results from the likely fact that much of the passive losses were funded by borrowed funds, and certainly have been if they exceed your cash investment in the deal.

If you have a partnership interest that you believe to be worthless and it does not fit the description of a passive interest in operating real estate described above, you may still be able to create an ordinary loss.

One approach is to abandon the asset, claim that it is worthless, and treat it as such under Section 165 of the Internal Revenue Code. The ordinary loss treatment will hinge on if you are “at risk” for any partnership liabilities under the partnership tax rules.

Failing that, holding the investment as simply worthless (not abandoned) might allow an ordinary deduction under Section 165 even if you are “at risk” for partnership liabilities. Yes, some research into your particular situation is required in these instances to see if you qualify.

You should consult with your tax adviser before pursuing any of the concepts discussed above since the concepts and calculations are tricky. However, don’t ignore an asset that no longer has value; figure out a way to make it work for you.

Better yet, identify those assets that in your judgment might be deemed worthless and ask your tax adviser to quantify the tax benefit to you. Remember, if you intend to abandon a partnership interest, you must notify the partnership before year-end if you want the abandonment to benefit your 2014 tax return.