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Taxed on income not received. Is it fair?

It’s a basic principle under US tax law for partnerships that partners are taxed on their “distributive share,” of the partnership’s income. These tax rules are often referred to as “Flow through taxation,” meaning that the income of the entity flows through to be taxed on the owner’s personal tax returns. A recent tax court case. Dodd, TC Memo 2021-118, illustrates the principle and a common problem that arises when the tax partnership owns real estate. The ruling against the taxpayer, Ms. Dodd is an application of fundamental partnership tax rules, but is the result “fair?”

In this case Ms. Dodd was a partner in the partnership which sold a building and reported a gain. Tax partnerships report a partner’s share of the partnership income on a Schedule K-1 that is filed with the partnership tax return and issued to the partner for their use in filing their personal tax return. Ms. Dodd’s K-1 showed a $1mill taxable gain resulting from the sale of the building. However, Ms. Dodd never received $1mill in distribution or other payment from the partnership. In fact, the cash received from the buyer of the building, over $1mill, was used to pay off a mortgage on that building.

Since she never received any payment for the income reported on the K-1, Ms. Dodd argued that she shouldn’t have to include in her personal income and pay tax on that gain. The Tax Court disagreed with Ms. Dodd and confirmed that she did owe tax on the $1mill gain. A partner’s income is not determined by what they received in payment from the partnership. Ms. Dodd’s income is determined by her distributive share of the partnership income, whether she receives payment from the partnership or not.

But is that “fair?”

My view is that fairness in taxation is a subjective discussion. So rather than providing a conclusive answer to that question, let me point out some math and tax mechanics to the situation that may not be immediately obvious.

Without getting into the specifics of Ms. Dodd’s case, this situation happens quite often in real estate partnerships. Investors often purchase properties with debt. Although the lender may have a mortgage or other lien on the property for accounting and tax purposes the property is owned by the investors. That entitles the investors to tax deductions related to the property such as depreciation and operating expenses.

Let’s suppose investors purchased a building for $1.3mill with a $300K down payment and a $1mill mortgage. That $1.3mill establishes the investors’ tax basis in the property. Over time if the building is not earning income that exceeds operating expenses, that tax basis could be depleted from tax deductions, primarily depreciation. Those tax deductions should have been available to the investors, as tax benefits, reducing their overall taxes.

A sometimes confusing tax results arises if the property is later sold with no increase in value. Supposed in our example the property is sold for $1mill and the original mortgage is still outstanding. Then there would be no cash for the investor from the sale, because it would be used to pay the lender. The investor however is deemed to have received that $1mill before paying the lender and has no remaining tax basis in the property. Thus, the investor has a $1mill gain. This gain is essentially recapturing the $1mill in tax deductions that investor was provided over the previous years when holding the property.

In the Dodd case, the investors held the property through a partnership. That doesn’t change this overall dynamic. So, without opining on the fairness of tax law, let me rephrase the question for you.

Is it fair that an investor who w

as allocated $1mill in tax deductions, would be required to recapture those deductions as a gain when the property is sold? They certainly didn’t receive a check for $1mill in that case, but they didn’t bear the economic cost of the $1mill in previous tax deductions they took either.

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