Abandonment of Partnership Interest

By Robert Klein

A taxpayer who abandons, or forfeits, a limited partner's ownership interest without consideration could be entitled to an ordinary loss deduction rather than a capital loss. This would be beneficial to a taxpayer who does not have capital gains to offset a capital loss from a real estate investment that has failed. If a partner abandons a partnership interest, or forfeits a partnership interest in accordance with the entity's agreement for no consideration, a loss is realized in the amount of the partner's adjusted tax basis. The character of the loss for tax purposes has been the subject of an Internal Revenue Service ruling and some court cases.

Generally, if a partner receives an actual or constructive distribution, or has a reduction in liabilities due to an event, any resulting loss is deemed from the sale or exchange of an interest. Under the tax code, the sale or exchange of a partnership interest would be a capital loss. However, an IRS ruling deemed a loss to be ordinary in a case where a limited partner abandoned a partnership interest, and the partner did not bear an economic risk loss for partnership liabilities nor include a share of partnership liabilities in adjusted tax basis. The IRS noted that the partner received nothing in exchange for the partnership interest, and the situation was similar to the partnership interest becoming worthless.

This ruling is consistent with the decision in court cases involving similar situations. One case involved the abandonment of a limited partner interest where there were no liabilities referenced to any of the limited partners. Since the abandonment did not cause a decrease in the limited partner's share of liabilities, a deemed distribution to the partner did not occur under the tax code. Thus, the taxpayer was entitled to ordinary loss treatment with respect to the abandonment of the partnership interest [Citron v.Commissioner, 97 T C 200].

In another case, a partnership owned a tract of unimproved land. Originally the partners expected a new highway would be built adjacent to the land which would attract development and a resale of the land for a profit. Worsening economic conditions and a delay in construction of the new highway resulted in the partnership being unable to sell the land. The partner indicated he would no longer contribute funds to the partnership and was going to walk away from the ownership interest in the partnership. The Circuit of Appeals Court ruled that the partner had abandoned the interest in the partnership and was entitled to an ordinary loss based upon worthlessness. [Echols v. Commissioner, 68 AFTR 2d 91-5157(953 F.2d 703].

To treat the loss as ordinary due to abandonment, rulings and cases discussed above all indicate that the partner must demonstrate an intent to abandon by some overt act or statement to give a third party notice. Whether an overt act has occurred must be determined based upon all facts and surrounding circumstances. Certainly written notification to the partnership should be part of the necessary steps to effectuate a proper abandonment.

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