Lost basis in a partnership

Question

Suppose I fund an LLC with 100k and my partner provides sweat equity, so we each own 50% of the LLC. Suppose this LLC has a single activity, a rental house bought by my 100k and worked on with that sweat equity, resulting in the LLC owning a house with a 100k depreciable basis but with a market value of 200k (ignore nondepreciability of land for simplicity). Now, 366 days later, I pay my partner 100k for his shares. What happens when the LLC becomes a disreguarded entity?

If my basis in the house now jumps to 200k, that would make sense, but a basis in LLC shares automatically converting to a basis in the property owned by the LLC seems unlikely how it is treated. That would get real complicated real fast if multiple assets are owned by the LLC.

If my 100k spent on shares is treated as a lost investment asset (when the partnership dissolves from a tax perspective), then my partner got a 100k cap gain selling his shares and I got a 100k cap loss. Makes sense, but doesn't feel like it is right.

If my 100k spent on shares is treated as an investment that has not been disposed, because I still do have the shares, then we just structured a way to spend 200k on a depreciable asset and dissappear 100k of that basis. Does basis really just dissappear like that?

So how does this actually play out? If it naturally plays out badly, how can it be done so as to avoid a bad outcome?

Answer 1

Suppose I fund an LLC with 100k and my partner provides sweat equity, so we each own 50% of the LLC.

I assume the operating agreement exists, and states that you each own 50% in the partnership equity, income, and losses.

Suppose this LLC has a single activity, a rental house bought by my 100k and worked on with that sweat equity, resulting in the LLC owning a house with a 100k depreciable basis but with a market value of 200k (ignore nondepreciability of land for simplicity).

What you're referring to is called "inside basis" and "outside basis".

Inside basis is the partner's basis in the assets the partnership (as a disregarded entity) owns.

Outside basis is the partner's basis in the partnership itself.

The partnership owns $200K in assets with $100K basis. Your outside basis in the partnership is $100K and inside basis is $50K, your partner's outside basis is $0 and inside basis is $50K.

Now, 366 days later, I pay my partner 100k for his shares.

Your outside basis is now $200K and inside basis is $100K, your partner's outside basis is -$100K and inside basis is $0, and he disposed of his ownership. Your partner recognized $100K capital gain.

If my basis in the house now jumps to 200k, that would make sense, but a basis in LLC shares automatically converting to a basis in the property owned by the LLC seems unlikely how it is treated. That would get real complicated real fast if multiple assets are owned by the LLC.

Your inside basis is $100K (basis of the asset owned by the partnership), and your outside basis is $200K (your basis in the partnership).

Some resources to further learn about this:

• The IRS has a nice presentation on the determination of the outside basis for auditors.

• Many accounting firms have articles on this (example, example, example)

• Considerations for calculating outside basis in conversion covered here.